Quotas and tariffs
There are two types of protection; Tariffs, which are taxes, or duties, on imported goods designed to raise the price to the level of, or above the existing domestic price, and non-tariff barriers, which include all other barriers, such as:
With no trade, equilibrium market price in the country will exist at the price which equates domestic demand and domestic supply, at P, and with output at Q. However, the world price is likely to be lower, at P1, than the price in a country that does not trade. If the country is opened up to free trade from the rest of the world, the world supply curve will be perfectly elastic at the world price, P1.
The new equilibrium price is P1 and output is Q1. The domestic share of output is now Q2,compared with Q, the self-sufficient quantity. The amount imported is the distance Q2 to Q1.
Imposing a quota
In an attempt to protect domestic producers, a quota of Q2 to Q3 may be imposed on imports.
This enables the domestic share of output to rise to 0 to Q2, plus Q3 to Q4.
The quota creates a relative shortage and drives the price up to P2, with total output falling to Q4. The amount imported falls to the quota level. It is this price rise that provides an incentive for less efficient domestic firms to increase their output.
One of the key differences between a tariff and a quota is that the welfare loss associated with a quota may be greater because there is no tax revenue earned by a government. Because of this, quotas are less frequently used than tariffs.
Tariffs, or customs duties, are taxes on imported products, usually in an ad valorem form, levied as a percentage increase on the price of the imported product. Tariffs are one of the oldest and most pervasive forms of protection and barrier to trade.
The impact of tariffs
The imposition of tariffs leads to the following:
Domestic consumers face higher prices, which also means that there is a loss of consumer surplus. However, there is a gain in domestic producer surplus as producers are protected from cheap imports, and receive a higher price than they would have without the tariff. However, it is likely that there is an overall net welfare loss.
Without trade, the domestic price and quantity are P & Q.
If a country opens up to world supply, price falls to P1, and output increases from Q to Q2. As a result, domestic producers’ share falls to Q1 and imports now dominate, with the quantity imported Q1 to Q2.
The imposition of a tariff shifts up the world supply curve to World Supply + Tariff.
The price rises to P2, and the new output is at Q3. Domestic producers share of the market rise to Q4, and imports fall to Q4 to Q3. The result is that domestic producers have been protected from cheaper imports from the rest of the World.
Given that domestic consumers face higher prices, they also suffer a loss of consumer surplus. In contrast, domestic producers increase their producer surplus as they receive a higher price than they would have without the tariff.
Increased market share also means that jobs will be protected in the domestic economy.
However, the reduction in consumer surplus is greater than the increase in producer surplus. Even when adding the tariff revenue (area K,L,M,N) there is still a net loss. The net welfare loss is represented by the triangles X and Y.
There is a potential distortion of the principle of comparative advantage, whereby a tariff alters the cost advantage that countries may have built up through specialisation.
There is the likelihood of retaliation from exporting countries, which could trigger a costly trade war.
However, in the short run tariffs may protect jobs, infant and declining industries, and strategic goods. Tariffs may also help conserve a non-renewable scarce resource. Selective tariffs may also help reduce a trade deficit, and reduce consumption.