Question

A small country initially has free trade in motorcycles, it has one local motorcycle producer, and imports account for over half of local motorcycle sales. The government has decided to impose a tariff of 20 percent, aimed to reduce motorcycle imports by about a third. The local producer proposes that a quota equal to two-thirds of the free-trade level of imports be imposed instead of the tariff because the quota will benefit the country by providing certainty about the import quantity.

(a) what is the effect of the tariff on domestic production?
(b) what is the effect of the quota on domestic production?

Answer 1

a. Tariffs increase the prices of imported goods. Because of this, domestic producers are not forced to reduce their prices from increased competition, and domestic consumers are left paying higher prices as a result. Tariffs also reduce efficiencies by allowing companies that would not exist in a more competitive market to remain open.When a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit the volume of imports.

The role tariffs play in trade has declined in modern times. One of the primary reasons for the decline is the introduction of organizations designed to improve free trade, such as the World Trade Organization (WTO). Such organizations make it more difficult for a country to levy tariffs and taxes on imported goods, and can reduce the likelihood of retaliatory taxes. Because of this, countries have shifted to non-tariff barriers, such as quotas and export restraints. Organizations like the WTO attempt to reduce production and consumption distortions created by tariffs. These distortions are the result of domestic producers making goods due to inflated prices, and consumers purchasing fewer goods because prices have increased.

Domestic producers benefit by ultimately facing reduced competition in their home market, which leads to lower supply levels and higher prices for consumers.

When a consumer does purchase a higher-priced imported good with a tariff imposed on it, the consumer now has less money to spend on other things. This forces consumers to either buy less of the imported good or less of some other good, ultimately lowering the purchasing power of consumers. It is important to remember that although consumers may pay higher prices because of tariffs and have limited options, the potential benefit is that domestic sales of goods can increase, ultimately leading to higher domestic sales and more jobs for companies inside the country.

b. A quota leads to an increase in domestic production, which results in an increase in local employment at the expense of consumers paying higher prices for the domestic product.

Some countries apply quotas to protect local industries from dumping. Dumping occurs when producers in foreign countries have unfair advantages to lower costs, such as subsidies or controversial labor laws allowing them to produce at a much lower cost. This means they can sell their products in a foreign market at a lower price than the actual cost of production.

To combat a quota and high price, sometimes a black market is created where smugglers illegally import the good to circumvent the quota. This could diminish the effectiveness of the quota.

The goal of a quota is to reduce imports and protect domestic production a good from competition abroad. As demand for the foreign good is artificially lowered, domestic consumers are forced to increase consumption of the domestically produced product.

An import quota has a protective effect. As it reduces the imports, the domestic producers are induced to increase the production of import substitutes. The increased domestic production due to import quota is called as the protective or production effect.

In such an event, the revenue effect is either captured by the domestic importers or foreign exporters, or shared between the domestic importers and foreign exporters in some proportion. It is, therefore, not easy to quantify exactly what the revenue effect of import quota will be and to which group or groups will it accrue and in which proportion.