Question

1. From the following figure, in which Dc and Sc refer, respectively to the domestic
   demand and supply curves of cloth, and SF and SF+T refer, respectively, to the world
   supply curve of cloth under free trade and with an import quota of 40C imposed by the nation on the importation of cloth, determine:

$2Q==$

1. The consumption, production effect, and the trade effect of the import quota.
2. The reduction in consumer surplus, the increase in producer surplus or rent, the import quota revenue, and the protection cost or deadweight loss to the economy as a result of the import quota.

1. Explain why and under what conditions the infant-industry argument for an import tariff is valid.
2. How must this argument be qualified?

Answer 1

i). A quota limits the physical quantity of import from a foreign country. As the quantity of import decrease the domestic price level increase due to the shortage of supply. The increased price level reduces the volume of consumption in the domestic market. The quota increases the price from $2 to $3 in the domestic market. The fall in consumption due to quota is the consumption effect. Before the imposition of quota the domestic consumption was 100 units. But after the quota imposition, the domestic consumption falls to 80 units. Thus consumption decreases by 20 units (100-80). The fall in consumption is the consumption effect relates to quota.

The increased price after quota from $2 to $3 gives an incentive to the domestic producers. Before quota the domestic production was 20 units. This low domestic production is due to the availability of low priced goods in the domestic market through import. But after quota the domestic producers increase their production from 20 units to 40 units. The increase in domestic production is 20 units (40-20) is the production effect of quota.

The trade effect is the change between in import before and after quota. Before the imposition of quota the total quantity imported was 80 units (domestic consumption 100- domestic production 20). But the increased price after quota reduces the domestic consumption to 80units and increase domestic production to 40 units. Thus the new quantity imported after quota is 40 units (new domestic consumption – new domestic production). The fall in import by an amount equal to 40 units is the traded effect. The quota reduces the volume of import.

ii) By comparing the consumer’s surplus before and after the quota, we can estimate what loss consumer suffer from the lack of consumption. Before quota at a price of $2 the domestic consumer’s surplus was $250, 7-2=5×100/2(base ×height/2). But after quota the consumer’s surplus reduced to $160, (7-3=4×80/2). The net loss to the consumers = $250-$160= $90.

At free trade the producer’s surplus was $10(2-1=1×20/2). The increased price from $2 to $3 after quota gives a total surplus of $40(3-1=2×40/2). The producer’s extra gain is $30(40-10). In other words the producer’s surplus increases by $30.

If the government gives the quota license at free of cost to the domestic importers there will be no increase in government revenue. It the government gives quota license through auction the government will get an amount equal to quota rent. The government revenue in this case is the difference between the free trade prices multiplied by the quantity of import after quota. The government get a revenue equal to $40( 3-2=1×40).

The deadweight loss or protection cost is the area of which arise out of lack of consumption and increased marginal cost due to increased production. In the figure the area GMN is the deadweight loss in the production side. The value of this area is $10(40-20=20×1=20/2). The total deadweight on the consumption side is represented by the area RHB. The loss is also $10(100-80=20×1=20/2). Total welfare loss after the quota is $20.

i) A protectionist policy like tariff is imposed on the ground of protecting the infant industries in the economy. The infant industries are in the early stages of production. The economies of scale and economies of scope are not available to the newly started industries. Economies of scale are the reduction in unit cost due to large scale production. Economies of scope on the other refer to the cost advantage due to the multiple products in a firm rather than producing a single product. Thus in the absence of economies of scale and economies of scope, the infant industries cannot compete with the big firms in foreign countries having low cost of production. Thus tariff as a protective method which is generally used to protect the domestic industries from the competition of low priced goods from the rest of the world. A tariff increases the price of imported goods which substantially reduce the volume of import.

ii) Protection under the wall of tariff cause lack of incentive on the part of domestic producers. The economic efficiencies like invention and innovations are the result of competition. In the absence of competition, the domestic industries lack productive efficiencies. Again the foreign countries retaliate the by imposing retaliated tariff from the export of tariff imposing country. This will reduce the countries net export. Lastly every tariff is a gain at the cost of domestic consumers. The consumers have to pay higher price and lacks the opportunity to choose commodities according to their choice.