Question

Question on Tariffs & Quotas:

TIUUUCL D. 20. Draw a graph to illustrate the effect of tariffs in the economy. Draw another graph to illustrate the effect of quotas. Remember to label the regions that represents gains/losses of surplus for the government, consumers, domestic producers, and foreign producers. Which policy is more detrimental to the domestic economy? Why?

Answer 1

Price (5) 55 + imports With free trade, price is P2, determined by world demand and supply and this results in an import of Q2-Q3 units. An import quota will set an upper limit on the amount of imports. This will restrict imports so that there is an increase in the domestic price and hence, domestic producer has an increased producer surplus. There is a reduction in the consumer surplus on the account of increased price and reduced quantity demanded. / DI CEH With quota in place, the supply curve is now a unique one. Till the world price is reached, only Q1 Q2 Q3 24 quantity demanded and domestic producers are supplying. At the world supplied price, foreign producers are supplying till the quota is reached. From then onwards, domestic firms start supplying again. This brings a new domestic market equilibrium at a price P1. Consumer surplus is the area of the region (A+B+C+D+E+F) which is now reduced to area (A + B). Producer surplus rises to an area (F + G) from an initial area (G). There was a deadweight loss equal to area (D+H) The government may give the rights (through auctions) to sell the quota to foreign producers. In this case, they would earn an additional arbitrage profit of the size of tariff revenue shown by area (C+E).

Price (5) Before tariff, the world price is P1 (line m) and at this price, domestic quantity demanded is Q4 and quantity supplied is Q1 so that initially the imports are Q4Q1. Consumer surplus is area of region A+B + C +D+E +F. Producer surplus is given by region G. there is no revenue to the government and there is no deadweight loss. F D C E PIG Tariff will increase in the domestic price (from P1 to P2) from line m to line 1. Quantity of imports is reduced to Q2Q3. The consumers are hurt the most because their surplus is now reduced to A + B. Domestic producers are at a lot of advantage because they face limited competition and increased price of their products. Q1 Q2 Q3 Q4 (quantity demanded and supplied) Their surplus rises from G to F + G. Government also benefits because it receives tariff revenues (C). Foreign nation will be hurt as its exports are reduced and its revenues plummet. There is a deadweight loss shown by the region D + E which is the net welfare loss to the nation.

An import quota will set an upper limit on the amount of imports. This will restrict imports so that there is an increase in the domestic price and hence, domestic producers experience an increased producer surplus. There is a reduction in the consumer surplus on the account of increased price and reduced quantity demanded. However, the overall economic welfare is reduced because loss to consumers is greater than the gain to producers. Tariff is a restrictive trade practice that attempt to favour trade for domestic producers and raise the price for consumers. It tends to limit the amount of imports being entered in the nation. Protective tariff is aimed at reducing foreign competition for domestic firms while Revenue tariff is a tariff that is imposed for collecting revenue from foreign imports. Tariff generates revenue which goes to the government. However, once again, the overall economic welfare is reduced because loss to consumers is greater than the gain to producers and the government. For the protection of domestic industry, quota is better than tariff. This is because tariff reduces competition for domestic industries but does not impose a limit. Quota set a limit on foreign supply and so domestic producers know the degree of competition they have to face. Tariff merely reduces the volume of foreign trade which again depends on market conditions.