Question

4.) a. Compare and contrast the impact to trade of Quotas and Tariffs. b. Some economists have argued that, because domestic consumers gain more from free trade than domestic producers gain from (import) tariffs and quotas, consumers should buy out domestic producers and rid themselves of costly tariffs and quotas. If this was feasible, would you be in favor? If there is a net loss to society from tariffs, why do tariffs exist?

Answer 1

Tariff is a tax imposed by the government of a country on the imported goods and services. Quota is fixation of physical quantity of goods and services that can be imported from the rest of the world. Both tariff and quota raise the domestic price and the consumers will be harmed and domestic producers gain. Under free trade the consumers gain much. The consumer's surplus will be larger. The producers will be losers under free trade. They have to reduce their production in the face of cheap imported item from foreign countries. The welfare gain is larger under free trade. But the tariff and quota increase domestic price and the producers gain from tariff and quota due to increased domestic price and increase in their volume of production. Both tariff and quota give some revenue to government. Under tariff the government gets revenue equal to the tariff multiplied by the quantity of import. Under quota the government gets quota rent iſ the government auctioned the quota license. By comparing the relative nel welfare under free trade and under restrictive trade policies we may arrive at a conclusion that the trade restrictions in the form of tariff and quota reduce net welfare of a nation. The net welfare effect under free trade and under trade restrictions can be analyzed by using a supply and demand diagram as shown below. Quota Pw+tta C D E FH Pw Q1 Q2 Q3 Q4 The domestic price level without trade is P and the quantity demanded and supplied is equal to Q. Suppose the world price (Pw)is lower that domestic price level (P). Thus the country trade with the rest of the world. At a world price of Pw the domestic demand is equal to Q4 and domestic supply is Q1. To meet the excess of demand over domestic supply the country importa quantity equal to Q1 Q4. At this free trade price the domestic consumer net gain is equal to the area B+C+D+E+F+I. The producers supply is limited to the area J only. The extra gain the nation derive from free trade is equal to B+C+D+E+F+I. Suppose the government impose cither a tariff or quota, both limit the import quantity from Q104 to Q2 Q3. Both increase the price from Pw to Pw+1+4. Aller tariff or quanta the domestic production increases from Q1 to Q2. Then the producers surplus increase from J to J+C. The government gets revenue in the form

of tariff quota rent equal to the area E+F. But both tariff and quota cause deadweight loss equal to the area D and I. This area is not available to anyone in the society. Thus the net welfare effect of tariff/quota is that it reduces national welfare. Before the trade restrictions the net welfare was equal to the arca BICIDIDIT II. But after impose restrictions on trade, the net welfare decrease to the area BIEF, the economy loss the areas D and I. In short free trade is beneficial to the importing country, tariff or quota reduce the national welfare. Each nation imposes tariff and other trade restriction by knowing that trade retractions will reduce net welfare. The tariff and other trade restrictions imposed by the importing country on the basis of the following reasons. 1. Protection of infant industries. Tariff will damage the domestic industries. In countries, particularly in developing countries, the industries are in the early stages of development. These industries are unable to compete with the industries of well developed countries. The industries in developed countries are highly competitive in the international market due to their long standing experience in the market and economies of scale of large scale production. The small industries in developing nations which are in early stages of development cannot compete successfully with the big firms in the developed countries. Thus the imposition of tariff is justified on the ground of protection of infant industries in a country. 2. Protection of domestic employment. Tariff and quotas are often imposed in order to protect citizens from job loss. In the event of increased import under free trade, the production in the domestic industries will decrease. This will create large unemployment within the country. So protective method are usually adoptee to protect the domestic employment opportunities. 3. National security. The import of certain items particularly the items used in nation defense must be prevented. A country cannot rely upon other country for the import to defense items. Depending on other country for the import of defense goods pause a serious threat to national security. To prevent the import of such items, the government imposes tariff and other trade restrictions 4. Balance of payment. Heavy import and less import creates deficit in the balance of payment of a country. To reduce the balance of payment deficit a country has to restrict its import. Thus imposition of tariff is recommended on the ground of reducing the balance of payment deficit. 5. Terms of trade. Tariff improves the terms of trade of a country. Terms of trade are the relative prices of export in terms of relative price of import. A tariff compels the exporting country to reduce the price in order to prevent the fall in price. This will improve the lcrms of trade. 6. Many countries impose tariff as a source of revenue to the government.