The Welfare Effects of Import Tariff and Quota: “Small” Country This presentation presents the basic analysis of small-country tariff analysis and develops the idea that a tariff is a combination of a consumption tax and a production subsidy. It then shows that a tariff is “third best”: it is worse than a production subsidy even when the interests of the tariff’s beneficiaries are fully protected. Finally, it compares tariffs and quotas.

What is a “small” country? In trade theory, a country is said to be “small” if events in that country can have no effect on worldwide free trade prices

What is a Tariff? A tariff is a tax on imported goods

The Effects of a Tariff A tariff is a tax on imported goods Tariffs raise the price of imported goods above the world price by the amount of the tariff. This Reduces consumption, … Increases production, and thereby … Reduces the amount imported

Effects of a Tariff on Prices and Quantities of Steel Domestic demand Domestic supply Equilibrium without trade Price after tariff Q S Q D Tariff Price before tariff World price Q S Q D Imports with tariff Quantity Imports under free trade of Steel

Welfare under free trade Price of Steel Domestic demand Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price before tariff World price Q S Q D Quantity Imports under free trade of Steel

Consumer Surplus after Tariff Price of Steel A B Domestic demand Consumer surplus after tariff Domestic supply Equilibrium without trade Price after tariff Q S Q D Tariff Price before tariff World price Q S Q D Imports with tariff Quantity Imports under free trade of Steel

Producer Surplus after Tariff Price of Steel Domestic demand Domestic supply Producer surplus after tariff Equilibrium without trade Price after tariff C G Imports after tariff Q S D Tariff Price before tariff World price Q S Q D Quantity Imports under free trade of Steel

Government’s Revenue from Tariff Price of Steel Domestic demand Domestic supply Tariff Revenue Price after tariff Imports after tariff Q S D E Tariff Price before tariff World Q S Q D price Quantity Imports under free trade of Steel

Effects of Tariff on Social Welfare Price of Steel A Domestic demand Domestic supply Deadweight Loss B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports after tariff price Quantity Imports without tariff of Steel

Welfare Effects of a Tariff Consumers of the imported good are worse off (compared to free trade) Producers of the imported good are better off The government gains some revenue Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government The decrease in total surplus is called the deadweight loss of the tariff.

The Effects of an Import Quota An import quota is a limit—imposed by the domestic government—on the quantity of a good that can be produced abroad and sold domestically.

The Effects of an Import Quota Price of Steel Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota Isolandian price with quota Equilibrium with quota Q S Q D World price Price without quota = Q S Q D Imports with quota Quantity Imports without quota of Steel

The Effects of an Import Quota Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off. Import license holders are better off they make a profit from buying at the world price and selling at the higher domestic price.

The Effects of an Import Quota Price of Steel A Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota B Isolandian price with quota Equilibrium with quota D Q S E' Q D C F World price Price without quota = E" Q S Q D G Imports with quota Quantity Imports without quota of Steel

The Effects of an Import Quota

The Effects of an Import Quota With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. The quota can potentially cause an even larger deadweight loss, if a political mechanism such as lobbying is employed to allocate the import licenses.