3 Import Subsidies and Production Taxes (24 points) Home is a small country in a perfectly competitive market for lumber. Under free trade, Home imports 100 spruce logs at the world price of $20 per log. Under pressure from forest preservation activists, Home government considers introducing a policy that would limit local production of lumber. Throughout this question assume that the supply and demand curves in Home are linear. (a) Suppose the government introduces an import subsidy of sm = $5 per log (an import subsidy acts like a negative import tariff). As a result, production of lumber in Home decreases by 20 logs while consumption in Home increases by 10 logs. Evaluate the effect of this policy on Home country's welfare (relative to free trade) by taking the following steps: (i) Illustrate the situation in a graph. (ii) Qualitatively (no numbers needed) describe the effects on consumer surplus, producer surplus, and government revenue and show them in the graph. (iii) Calculate the net effect on Home country's welfare (provide a number). Relate your calculation to the graph. (b) Suppose instead that the government introduces a production tax of tp = $5 per log (a production tax acts like a negative production subsidy). Evaluate the effect of this policy on Home country's welfare (relative to free trade) by following the same steps (i)-(iii) as in part (a) above. (C) Now compare the two policies. (i) Which policy aimed at reducing domestic production is better in terms of country's overall welfare? (ii) What is the targeting principle? Explain the general idea briefly and relate to the problem studied in this question. 3 Import Subsidies and Production Taxes (24 points) Home is a small country in a perfectly competitive market for lumber. Under free trade, Home imports 100 spruce logs at the world price of $20 per log. Under pressure from forest preservation activists, Home government considers introducing a policy that would limit local production of lumber. Throughout this question assume that the supply and demand curves in Home are linear. (a) Suppose the government introduces an import subsidy of sm = $5 per log (an import subsidy acts like a negative import tariff). As a result, production of lumber in Home decreases by 20 logs while consumption in Home increases by 10 logs. Evaluate the effect of this policy on Home country's welfare (relative to free trade) by taking the following steps: (i) Illustrate the situation in a graph. (ii) Qualitatively (no numbers needed) describe the effects on consumer surplus, producer surplus, and government revenue and show them in the graph. (iii) Calculate the net effect on Home country's welfare (provide a number). Relate your calculation to the graph. (b) Suppose instead that the government introduces a production tax of tp = $5 per log (a production tax acts like a negative production subsidy). Evaluate the effect of this policy on Home country's welfare (relative to free trade) by following the same steps (i)-(iii) as in part (a) above. (C) Now compare the two policies. (i) Which policy aimed at reducing domestic production is better in terms of country's overall welfare? (ii) What is the targeting principle? Explain the general idea briefly and relate to the problem studied in this