Tariffs, quotas, export subsidies and their welfare effects

What trade restrictions are there?

Trade restrictions (trade protection) are government policies that limit how freely households and firms trade across borders. They differ by who imposes them and by who keeps the money.

Trade restrictionspolicies that limit free trade

• Imposed by the importer Memorize
  • Tariff Memorize tax on imports; the government keeps the revenue
  • Import quota Memorize cap on quantity; rent depends on who gets the licenses
  • Domestic content provision Use it minimum share of local inputs
  • Embargo a ban on trade with a country
• Imposed by the exporter Memorize
  • Voluntary export restraint (VER) Memorize exporter caps its own shipments and keeps the rent
  • Export subsidy Memorize payment per unit exported

A tariff is a tax on imported goods. An import quota caps the quantity that may be imported, usually through import licenses. A voluntary export restraint (VER) is like a quota, except that the exporting country imposes it on itself. An export subsidy is a payment per unit exported. Domestic content provisions require a share of a product’s value or parts to be local.

Restriction	Imposed by	What it does	Who keeps the rent
Tariff	Importing country	Taxes imports	Importing government (revenue)
Import quota	Importing country	Caps import quantity	Government if it auctions licenses; otherwise importers or foreign exporters
Voluntary export restraint	Exporting country	Exporter caps its own shipments	The foreign exporter
Export subsidy	Exporting country	Pays per unit exported	No one: it costs the government
Domestic content provision	Importing country	Requires local inputs	Not applicable

Why do governments do it?

Reasons for restrictions

• Protect established industries from foreign competition
• Protect infant industries until they mature
• Protect jobs domestic employment
• Strategic industries national security
• Raise revenue especially developing countries
• Reduce a trade deficit a stated aim of some tariffs
• Retaliation against other countries' restrictions

The infant industry argument asks for protection until a new industry is strong enough to compete. The risk is that protection never ends.

What does “small country” mean?

A small country is a price taker in the world market for a good: its trade cannot move the world price. It has nothing to do with area, population or gross domestic product (GDP). A big economy can still be a price taker in a market where its purchases are a small share of world trade.

A large importer can push the world price down. A tariff then shifts part of its cost onto foreign exporters, who cut their price to hold market share. In theory a large country can improve its welfare this way if the partner does not retaliate and the deadweight loss is smaller than the terms-of-trade gain. World welfare still falls.

What does a tariff do?

Memorize

In a small country the tariff lifts the domestic price from the world price $P^{*}$ to $P^{*} + t$. At the higher price domestic firms produce more and households buy less, so imports fall on both counts.

$$P_t = P^{*} + t$$

Tariff of t per unitdomestic price rises to P* + t

• Consumers lose A + B + C + D Memorize higher price, less consumed
• Producers gain A Memorize higher price, more output
• Government gains C Memorize tariff revenue on remaining imports
• Country loses B + D Memorize the deadweight loss
  • B inefficient extra domestic output
  • D mutually beneficial purchases that no longer happen

Consumers lose areas A + B + C + D. Producers gain A. The government gains C. The country as a whole loses B + D. Revenue (C) moves from consumers to the government, so it nets out. The deadweight loss is what is left: B is the cost of domestic firms producing units that the world could supply for less, and D is the value of purchases that no longer happen.

Each area is a rectangle plus a triangle: the tariff times a quantity, plus half the tariff times the change in quantity. For consumers the rectangle uses consumption after the tariff (720); for producers it uses output before the tariff (300). That factors to the tariff times (the quantity plus half the change), which is the fastest way to key it in.

$$\Delta CS = t\,Q_{d,\text{after}} + \tfrac{1}{2}\,t\,\Delta Q_d$$

$$\Delta PS = t\,Q_{s,\text{before}} + \tfrac{1}{2}\,t\,\Delta Q_s$$

$$R = t \times (\text{imports after the tariff})$$

$$DWL = \tfrac{1}{2}\,t\,\Delta Q_s + \tfrac{1}{2}\,t\,\Delta Q_d$$

Exam tip Imports after the tariff are demand after the tariff less output after the tariff (720 − 380 = 340). Charging the tariff on the old import quantity is a classic wrong answer.

How does a quota differ?

An import quota with the same cap as the tariff leaves imports at 340 and the domestic price at EUR 50. Every area is the same, but the box C now has a different name: quota rent , the extra profit earned because supply is capped and the price is held above the world price. Who gets it depends on who holds the import licenses.

• Government auctions the licenses: it collects C, and the loss to the country is B + D = 800, as with a tariff.
• Licenses go free to foreign exporters (or the exporting government): the rent leaves the country and the loss is B + C + D = 800 + 3,400 = 4,200.
• Licenses go free to domestic importers: they keep the rent and the loss is the same as the tariff for the country, but the government raises nothing.

A VER fixes the rent abroad by design. The exporter imposes the cap on itself and keeps the whole of C, so the importing country always bears B + C + D. VERs were often used to avoid a formal quota, and for the importer they are worse than a tariff.

$$\text{Loss} = B + C + D$$

What does an export subsidy do?

An export subsidy is paid by the exporter’s own government on each unit sold abroad. Exporters earn the world price plus the subsidy abroad, so they shift sales from home to export markets. The domestic price rises by the amount of the subsidy (small country), domestic consumption falls and exports rise.

National welfare falls because the policy pulls production away from comparative advantage and costs the government money. For a large country the extra exports also push the world price down, which hands part of the subsidy to foreign buyers, so the loss is bigger. An importing country may respond with countervailing duties , which are extra duties on subsidized imports.

How do the restrictions compare?

	Tariff	Import quota	Export subsidy	VER
Country affected	Importer	Importer	Exporter	Importer
Domestic price	Up	Up	Up	Up
Domestic production	Up	Up	Up	Up
Domestic consumption	Down	Down	Down	Down
Trade	Imports down	Imports down	Exports up	Imports down
Government revenue	Up	Mixed	Down (spending)	No change (rent abroad)
National welfare	Down (small); could rise (large)	Down (small); could rise (large)	Down	Down

Go deeper Large-country tariffs and the terms of trade

A large importer faces an upward-sloping world supply curve, so a smaller quantity means a lower world price. The tariff improves its terms of trade, a gain that offsets some or all of the deadweight loss. This is the logic behind an “optimal” tariff. It works only if trading partners do not retaliate, and it comes at a bigger cost to the exporters, so world welfare still falls.

Go deeper Why were VERs popular, and why are they worse for the importer?

A VER lets the importing government restrict trade without a formal quota or tariff, and the exporter agrees because it keeps the rent. For the importer, that same feature makes it costlier than the equivalent tariff, since it forgoes the revenue and the rent leaves the country.