What happens if domestic price is lower than world price?
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4 Keys to Trade and Tariff Graphs7/11/2020
Jacob Reed To understand the ins and outs of trade and tariff graphs, you first need to have a firm grasp on the basics of supply and demand. Assuming you have that, we are ready to begin.
Let’s use the oil market as an example and start with an economy that does not trade oil with other countries. That means the equilibrium price (Pe) and quantity (Qe) for oil within the country will be determined by the intersection between domestic (as opposed to foreign or worldwide) supply (DS) and domestic demand (DS). As you may have already learned, when the market reaches equilibrium consumer surplus will be the triangle above the price up to the demand curve and the producer surplus will be the triangle below the price down to the supply curve.  2. How is the world price determined and how does it impact the domestic market? Internationally the price of oil will be determined by the international supply and demand for oil. Since the international market is so much larger than the domestic market, domestic consumers and domestic producers will not be able to impact the international price. As a result, the international price
creates a perfectly elastic world supply curve (Sw) at the world price (Pw). If this country trades oil with other countries, consumers will be able to purchase all the oil they want at the world price and producers will be able to sell all the oil they want at the world price. Due to the lower world price, producer surplus decreases. It is found in the triangle from the world price down to the domestic supply curve. Consumer surplus increases dramatically; by much more than the amount of producer surplus lost. It is found in the triangle from the world price to where it intersects the domestic demand curve up to the domestic demand. As a result of the imported consumption, total economic surplus (consumer surplus + producer surplus) within this market increases. 3. How will a tariff impact a market? At this new higher world price (thanks to the tariff) domestic producers will produce higher quantities. That is because domestic producers do not have to pay the tariff, but they do get to charge the new higher price. So, domestic production will increase to Q3 (from Q1). Also, at the new higher price, consumers will demand fewer barrels of oil so consumption will decrease from Q2 to Q4. This economy will still import oil but will import few barrels (Q4-Q3 instead of Q2-Q1). 4. How does a tariff impact efficiency? Now that you have a good grasp on how trade and tariffs impact the supply and demand graph, practice with these graphs in the shading practice or important prices, points and quantities game. Note: Import quotas have a similar impact on a domestic market as tariffs do. Trade quotas establish a quanity or monetary limit on the amount of a good that can be imported. They help the domestic industry, but they create deadweight loss and hit consumers with higher prices in much the same way tariffs do. What happens if world price is higher than domestic price?Since the world price is higher than the domestic price, producers will continue to sell in the worldwide market rather than the domestic market until the domestic price increases to the world price; thus, domestic demand will decline.
Why would a domestic price be different than the world price?In the absence of trade, the domestic price is determined by the equilibrium between domestic supply and demand. Once a country opens up to trade, the price of an item becomes the world price. The world price is determined by world supply and demand.
What will happen if a country allows trade and the domestic price of a good is higher than the world price?If a country allows trade and the domestic price of a good is higher than the world price, the country will become an importer of the good. If a country allows trade and the domestic price of a good is lower than the world price, the country will become an exporter of the good.
What happens when domestic price rises?Price levels are leading indicators in the economy; rising prices indicate higher demand leading to inflation while declining prices indicate lower demand or deflation.
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