Problem
Home is a small country in a perfectly competitive market for dairy. Under free trade, Home imports 80 liter of milk at the world price of $10 per liter. Under pressure from farmed animal protection activists, Home government considers introducing a policy that would limit local production of milk. Throughout this question assume that the supply and demand curves in Home are linear.
Suppose the government introduces a production tax of tp = $2 per liter (a production tax acts like a negative production subsidy). Evaluate the effect of this policy on Home country's welfare (relative to free trade).
1. Illustrate the situation in a graph.
2. Qualitatively (no numbers needed) describe the effects on consumer surplus, producer surplus, and government revenue and show them in the graph.
3. Calculate the net effect on Home country's welfare (provide a number). Relate your calculation to the graph.