Question

The home country imposes a limitation on the quantity of imported goods from other countries. How does this quota affect international equilibrium. Diagram using the offers curve and explain.

Answer 1

Import Quota is a physical limitation on the quantity of goods imported from other country. With the imposition of a quota the following events takes place:

1. When the quantity of imported item is restricted in any country, it creates a situation of excess demand i.e. shortages and consequently increases its price.

2. Due to import reduction, the domestic producers are induced to increase the production of those goods which are substitutes of the imported goods.

3. As quota increases the price of imported goods, it leads to a fall in the consumption of that good.

4. Due to high prices and less demand there is a loss in the consumer surplus.

5. Due to higher prices and an opportunity to increases production lead to an increase in producer surplus.

6. Import restrictions are also a tool to improve the balance of payments of the domestic country.

Before we move to the offer curve analysis lets understand the below terms:

A. Terms of Trade: It is the relation between a country’s export price and import price. If export price is higher than the import price, it means it has favorable terms of trade. If a country’s export prices are relatively less than the price of imports then it experiences unfavorable terms of trade. Terms of trade determines the redistribution of gains when countries indulge in trade with each other.

B. Offer curve of a country records the quantity of a good it exports to another country and the quantity of good it imports from the other country.

Imposition of quota could lead to welfare losses and create international disequilibrium by influencing the terms of trade.

o If the import-restricting country faces an elastic offer curve or it has a monopsony power, it will experience favorable terms of trade.

o If the exporting country faces an elastic offer curve or it has a monopsony power, the import restricting country will experience unfavorable terms of trade.

In the below diagram, let there be 2 countries “A and B” and 2 goods “Jute and Cotton”. Let’s assume that Country A is the quota – imposing country.

· Jute is the exportable commodity whereas cotton is the importable commodity for country A

· OA represents the offer curve for country A : It shows the quantity of jute it supplies/exports to country B and the quantity of cotton it imports

· OB represents the offer curve for country B : It shows the quantity of cotton it supplies/exports to country A and the quantity of jute it imports

· These offer curves intersect at point of exchange P, which is the international equilibrium i.e. simultaneous equilibrium in both the markets i.e. for both cotton and jute market. Originally,

J0 is the quantity exported by country A and imported by country B

C0 is the quantity exported by country B and imported by Country A

· The slope of straight line OP measures the terms of trade

· When an import quota of amount OC is imposed on the import of cotton by Country A, the trade now can either take place at point P1 or Point P2.

o If trade takes place at P1, the slope of the line OK1 shows the terms of trade. Since, OK1 is steeper than OP, thus terms of trade are favorable to the domestic country A.

o If trade takes place at P2, the slope of the line OK2 shows the terms of trade. Since, OK2 is flatter than OP, thus terms of trade are unfavorable to the domestic country A.

Because of the above two scenarios, we can say that there is an uncertainty in determining the terms of trade upon the imposition of quota restraints.