ABC of the economics of tariffs and import quotas-II

To summarise, the main results from the imposition of a tariff on the importing country are the following:
1. Quantity of imports falls and domestic prices inclusive of tariffs rise.
2. Domestic producers gain.
3. Domestic consumers lose.
4. Government gains.
5. Domestic economy also gains as a result of lower world price (a terms of trade gain).
6. If the country is relatively small, effect 5 above is very small, and there are net welfare losses because consumers lose more than producers and the government gain.
Our analysis is, of course, conducted with many simplifying assumptions. In particular, it done in a partial equilibrium framework and under the assumption that markets are perfectly competitive. However, economic analysis shows that in most cases the results of partial equilibrium analysis still carry through to a general equilibrium framework.
THE ECONOMICS OF IMPORT QUOTAS An import quota is a direct restriction on the quantity that may be imported of a good. An example of this is the case of textile quotas. Many industrial countries, including the United States (US) and the major European countries, imposed quotas on the imports of textile and clothing products from developing countries in 1974 under the Multi-Fibre Agreement (MFA).
In 1995, the MFA was replaced by the Agreement on Textiles and Clothing (ATC), which scheduled a gradual phase-out of the quantitative restrictions in several stages over a ten-year period, with quotas finally completely eliminated starting January 1, 2005.
This has led to serious concerns about how Pakistan's export performance will fare in the now quota-free environment. To understand the implications for Pakistan, it is first necessary to know what economic theory has to say about the implications of quotas - and their removal - for both the importing and the exporting countries.
SITUATION WITHOUT QUOTAS For the importing country, the initial situation is very much like the one discussed in the previous section before the introduction of tariffs. We reproduced it in Figure 5, but for the sake of change with slightly different illustrative numbers.
The initial world price is $100, which is the price at which the domestic country can import the good. At this price, domestic production is 400 units of the goods and domestic demand is 1,000 units, so that 600 units are imported from abroad.
EFFECTS OF QUOTAS Now suppose we are talking about the textiles and clothing market and the US (say) imposes a quota of 200 units on the imports of these items. The exact implications depend on how the quota is enforced. One example is the imposition of quota by the US on imports of foreign cheese.
In this case, import licenses are given to certain trading firms, each of which is allocated the right to import a maximum quantity of cheese each year. In other important cases, such as quotas on imports of sugar or imports of apparel under the MFA or ATC, the right to sell in the importing country is given directly to the government of exporting countries. Since we want to focus on the textiles example, which is more pertinent to Pakistan, we will assume that the license is issued directly to foreign exporters.
The domestic price has to rise to reduce desired imports of textiles and clothing by the US to the quota amount of 200 units. In the example shown in Figure 5, the domestic price has to rise to $110 to reduce imports to 200 units. When the price has risen to $110, domestic producers increase their production from 400 units to 700 units and domestic demand falls to 900 units.
Note, that an import quota always increases the domestic price, so we should not be under the misconception that import quotas somehow restrict imports without causing a rise in the domestic price.
What are the welfare effects of this quota imposition in the importing country - the US in our example? Again, we can add up the gains and losses of the different groups.
When the price rises to $110, there will be loss of consumer surplus in the US amounting to the sum of the shaded areas A, B, C and D. At the same time, there will be an increase in producer surplus from the price rise, amounting to the shaded area A. There is no effect on government revenues. The quota rents being generated as a result of the rise in price to $110, which amount to the shaded area C, accrue to the foreign exporters who hold the export licenses.
The net welfare loss is, then, given by:
NET WELFARE LOSS = LOSS OF CONSUMER SURPLUS - GAIN IN PRODUCER SURPLUS = (A+B+C+D) - A = B+C+D > 0
For the importing country (US), there is thus unambiguously a net welfare loss. Part of the consumers' loss is due to more costly domestic textiles being substituted for cheaper foreign textiles and part of it is due to less quantity being consumed.
Domestic producers gain because they sell more and at a higher price. Note, that only a part of the losses of the consumers are offset by the gains of the producers (the area A). The rest of the area (B+C+D) represent net efficiency losses to the importing country from distortions of domestic incentives to consume and produce and from accrual of quota rents to the foreign exporters.
How do these quota restrictions by the importing country (the US in our example) impact on the exporting country (Pakistan, say)? First, those exporters that are able to still export - namely, the holders of the 200 unit quota licenses to sell in the US market - gain by the amount of the quota rents, as already discussed. Second, those exporters who were exporting before (recall 600 units were exported before the quota restriction came into place), but are no longer able to export, will lose out.
EFFECT ON IMPORT PRICES OF QUOTA REMOVAL WITH MORE THAN ONE FOREIGN SUPPLIER Now we consider the effect on import prices of imposing a quota on the most efficient supplier and its implications, as the quota is then gradually relaxed and then finally eliminated, as in the case of textile quotas under the ATC. The example is stylised, but meant to illustrate the consequences for the less efficient producers.
Suppose the situation is as depicted in Figure 6. There are two potential foreign country suppliers, supplying goods that are perfect substitutes in the import basket of the domestic country.
COUNTRY A is a more efficient supplier than country B and can supply imports to the importing country at a price of $100, which is lower than the price of $120 at which country B can supply imports. All domestic producers are assumed to be less efficient than either foreign supplier, which follows because the domestic supply curve is assumed to hit the vertical axis at a price higher than $120.8
Equilibrium without an import quota is represented by point E. All 500 units of the good consumed are imported at $100 a unit from country A. Country B and domestic producers being less efficient provide none of the goods consumed. Now suppose an import quota of 200 units is imposed on country A only. This will raise the import price to the price at which the next efficient supplier can supply the goods, which is country B at a price of $120.
Intuitively, this is because the quota on the most efficient producer implies that the importing country will inevitably have to turn to other less efficient producers. At the new price of $120, 300 units will be demanded, which will still all be imported - 200 units imported from country A (up to its quota limit) and 100 units imported from country B. The producers in country A who still hold the licenses to export the 200 units will get quota rents of the amount shown by area R.
Suppose now the import quota of 200 units on country A is gradually relaxed. The price effects will be as shown by the arrows in the figure. Until the quota reaches 300 units, nothing will happen to the price and the amount of imports will shift in source from country B to country A. Once the quota of 300 units is reached, the import price will start to fall and we will gradually move along the part of the demand curve represented by the segment BE and country A's quota rents will gradually decline.
Once we reach point E we are back to the equilibrium without quotas, since the quota becomes non-binding. Country A would have recaptured the whole market at that point.
Thus, we can see that the presence of quotas may have allowed some countries like country B that were not as efficient as country A to remain in the market. However, in the absence of quotas, the third party competition may lead these countries to lose their market share unless a competitive edge is developed and maintained against the most efficient producers.
This result underscores the importance of third-party competition and the difficulties that some countries might face in the post-quota environment for textile trade. If a country like China, say, is more efficient like country A in the example above, it might be difficult for other countries (perhaps Pakistan, hypothetically) that are like country B to compete without becoming as efficient.
SUMMARY OF THE MAIN RESULTS The main results with respect to the effects of the imposition of an import quota may be summarised as follows:
1. Domestic price rises and obviously the quantity of import falls because of the quota.
2. Domestic producers gain.
3. Domestic consumers lose.
4. The losses of domestic consumers are more than the gains of the domestic producers, thus leading to a net welfare loss in the importing country.
5. Those foreign exporters who are still able to export and hold quota licenses gain, but other exporters who potentially could be exporting without the quotas lose.
6. Quota restrictions may allow some inefficient exporters to survive, which will be difficult to do (without matching the efficiency of the most efficient producers) when the quotas are removed.
These results suggest that when existing quotas were eliminated, as in the case of the textile quotas starting January 1, 2005, the import price in the importing countries, such as the US and the EU countries should have fallen and there should have been a net welfare gain in these countries, with the losses of domestic producers being more than made up for by the gains of domestic consumers.
Moreover, among the producers and exporters there will be gainers and losers. The less efficient exporters will lose market share to the more efficient exporters, unless they can improve their efficiency and international competitiveness.
The purpose of this article was to provide a flavour of the textbook economic arguments for the benefits of free trade and for why trade restrictions such as tariffs and import quotas are likely to lead to net welfare losses. It was shown that under standard textbook assumptions, the imposition of both tariffs and import quotas lead to net efficiency losses.
There are some gainers - domestic producers in the importing country gain, the government also gets more revenue in the case of a tariff, those exporters in the exporting country who manage to get the quota licenses also gain - but these gains are more than offset by the large losses that consumers suffer.
Consumers face these losses because the distortions resulting from these restrictions mean that they have to consume less and at a higher price because of the substitution of some production from the most efficient producers to less efficient ones.
Often the argument for free trade does not get a fair hearing because the interest groups who stand to lose from free trade are very vocal, visible and influential.
By contrast the large aggregate gains which occur from free trade are often very diffuse and made up of rather small gains per consumer but summed over millions and millions of consumers. This makes the formation of special interest groups and political influence more difficult.
It should be emphasised, though, as was noted when we began, that the world of textbooks is a very simplified one. In the real world, which is more complex, many other issues arise. For example, tariffs are distortionary but so is any other tax that is not lump-sum and yet some amount of government revenue has to be raised.
The existence of some tariffs may be optimal as part of a general package of taxes and public finance considerations. Moreover, for free trade to work best, it must operate from both sides involved in any international trade. This raises concerns having to do with perceptions of the lack of a level playing field being provided by the other side, which is the source of complications and stalling of WTO negotiations, for example.
There can be problems related to efficiency versus equity as well. What should be done when the inefficient domestic producers going out of business leads to large employment losses, particularly of low-skilled relatively poorer workers?
The free trade argument often rests on the principle that there are net efficiency gains, so that the gainers could in principle compensate the losers and still be better off on balance. But redistributions required to prevent the poor from becoming poorer hardly ever occur.
There are other political economy considerations as well. For example, there is an argument for deviating from free trade that rests on domestic market failures. If some domestic market fails to function as it should, deviating from free trade might help reduce the consequences of this malfunctioning.
This rests on the theory of second best, which states that if one market does not work properly it may no longer be optimal for the government to abstain from intervention in other markets.
Some also argue for the protection of key infant industries until they can get beyond their baby steps and for protection of key strategic industries (which might involve national security considerations) from foreign competition.
In this article, we do not take particular positions on these complex issues. The goal rather was more modest; the main point was that, in order to understand these more complex issues and appreciate the debate on them, one must first understand the textbook case for free trade and why trade restrictions could cause national welfare to fall in principle.
It is hoped that after reading the article carefully, the reader can better follow and appreciate the basics of the economics of tariffs and import quotas, which is a crucial starting point for an understanding of the issues involved in the debate about free trade.
(Concluded)