Question

Assume markets are perfectly competitive. By means of carefully drawn graphs, illustrate the costs and benefits of: (1) a tariff for the importing country; (2) an export subsidy; and (3) an import quota. How do the welfare effects of voluntary export restraints compare with tariff and quotas policies?

Answer 1

(1) Effect of a tariff for the importing country (figure 1)

In figure 1, D and S represents the demand and supply curve of the commodity. If free trade is conducted, the price of the commodity would be Pw. At this price, Qws is the quantity of the good supplied and Qwd is the quantity of good demanded. When a tariff is imposed, the price of the commodity in the importing country increases from Pw to Pt (by the amount of tariff imposed). The quantity supplied increases from Qws to Qts and the amount of quantity demanded falls from Qwd to Qtd.

Consumer surplus = area above the price line and below the demand curve

producer surplus = area below the price line and above the demand curve

The overall impact of tariff can be summarized as follows:

Fall in consumer surplus = -(A+B+C+D)

increase in producer surplus = A

rise in government revenue = C

Net effect on welfare of the importing country = -(B+D)

figure 1

(2) effect of an export subsidy (figure 2)

In figure 2, D and S represents the demand and supply curve of the commodity. If free trade is conducted, the price of the commodity would be Pw. At this price, Qws is the quantity of the good supplied and Qwd is the quantity of good demanded. When an export subsidy is provided, it raises the prices that suppliers get in an exporting country. The price increaes by the amount of the subsidy, from Pw to Ps. At this price, the quantity supplied increases from Qws to Qss and the amount of quantity demanded falls from Qwd to Qsd.

Consumer surplus = area above the price line and below the demand curve

producer surplus = area below the price line and above the demand curve

The overall impact of subsidy can be summarized as follows:

Fall in consumer surplus = -(A+B)

increase in producer surplus = A+B+C

fall in government revenue = -(B+C+D)

Net effect on welfare of the exporting country = -(B+D)

figure 2

(3) effect of import quota (figure 3)

Import quota basically restricts the amount of a commodity the one country purchases from the other country. Import quota raise the price of the good that is being imported. When imports are restricted, it leads to an excess demand at the initial price level. This causes the price to build up in order for the market to clear.

In figure 3, D1 and S1 represents the demand and supply curve of the commodity. If free trade is conducted, the price of the commodity would be Pw. At this price, Qws is the quantity of the good supplied and Qwd is the quantity of good demanded. When an import quota is imposed, the price of the commodity in the importing country increases from Pw to Pw+q (by the amount of tariff imposed). The quantity supplied increases from Qws to Qs and the amount of quantity demanded falls from Qwd to Qd. There would be the same impact, if instead of quota, a tariff of t = Pw+q - Pw was imposed.

Consumer surplus = area above the price line and below the demand curve

producer surplus = area below the price line and above the demand curve

The overall impact of quota can be summarized as follows:

Fall in consumer surplus = -(A+B+C+D)

increase in producer surplus = A

quota rent = C

Net effect on welfare of the importing country = -(B+D)

figure 3

Voluntary export restraints (VER) is a quota on trade that is imposed on the exporting country's side instead of the importing country's side. From the importing country's point of view, VER is exactly like an import quota but the difference is that the quota rents are now earned by the foreign country. So the area C that we observed in figure 3 is now captured by the exporters of the foreign country.

So, under VER the net effect on the importing country becomes = -(B+C+D) which suggests that VER is always costly to the importing country as compared to quota and tariff (which have a net welfare effect of -(B+D). This is the difference in the welfare effects of voluntary export restraints to that of tariff and quotas policies.

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