Eastwood's ECO486 Home Page

Chapter Seven Exercises

1. In what ways are tariffs and quotas similar in their effects? In what ways do they differ?

Similarities

bulletThey both result in higher domestic prices, an increase in domestic production of the good and a decrease in imports.
bulletConsumer surplus decreases by the same amount (for a tariff-equivalent quota). Producer surplus increases by the same amount.
bulletDeadweight costs are the same. (If the quota rents are both captured by the importing country and not wasted on rent-seeking activities).

Differences

bulletUnder an equivalent quota, the distribution of quota rents equivalent to the tariff revenue can vary. It can be given to domestic producers or importers, foreign governments or foreign producers, or auctioned and retained by the government.
bulletIn the longer run, a quota will impose larger distortions on an economy than would a tariff. When domestic demand increases, a tariff would allow the price to remain constant at the world price plus the tariff, and imports to increase. A quota will lead to a rising price, a constant level of imports, and larger deadweight costs.

2. Suppose that prospective importing firms hire lobbyists to help them secure from government authorities the right to import quota restricted items into a country. How much would importers as a group be willing to pay lobbyists for their services? Explain. Suppose lobbyists are paid this amount. What happens to domestic welfare in this case?

Suppose the market for this good is as illustrated above (Or as in Figure 7.1 (page 188) in the text. The prospective importers would like to obtain all of the quota rents represented by area c (c1 +c2). As a group, they should be willing to pay the lobbyists anything up to this amount to obtain the rights for them. If they are required to pay exactly $c, they will pay all of the quota rent gained to the lobbyists. If they paid more than $c, it would cost them more to obtain the quota rights than they can earn by importing and selling the good at the higher domestic price.

Suppose that the importers pay all $c to lobbyists in return for the import licenses. Since the importers are paying more for the good than it is worth in world markets, and since the lobbyists are only acting to insure that one group of importers rather than another receives the quota rights, they are providing nothing of value to the economy as a whole. Hence, deadweight costs rise by $c. Resources are used, but society receives nothing in return.

3. Suppose that a country requires special inspections on an imported food but it exempts domestic production from similar inspection. What effect would this have on imports, domestic production, prices, and quantity consumed?

This would be a type of nontariff barrier. The special inspection of imports means foreign producers will have higher production costs (in time, if nothing else) compared to domestic producers. Extra time could be especially costly for perishable items, such as fresh produce. The price of the good will be higher, imports will be fewer, domestic production will be higher, and the total domestic consumption will be lower than in the absence of the special inspection.

4. Show graphically that a monopolist will charge a higher price and produce at a lower level of output with quota protection than with tariff protection that yields the same level of imports.

 

Suppose the market for this good is as illustrated above. In this case, the domestic supply curve is the marginal cost curve of just one firm (the monopolist) rather than the sum of all firms’ marginal costs. In free trade at price Pw, imports would equal the amount (Qc - Qx) and the domestic producer faces a competitive market. Consider a tariff in the amount (Pt - Pw). The price would rise to Pt, and imports would decrease to (Qct - Qxt). The domestic producer is still forced to behave competitively (charging Pt) because the tariff simply adds to foreign producers’ costs.

Suppose the tariff was changed to a quota and imports were strictly limited to (Qct - Qxt). The domestic producer can now exercise his monopoly power. He knows that the market demand curve, D, minus imports under the quota, will be the demand curve facing his firm. Note that D-quota parallels D, with the distance  between them equaling the quota-restricted imports. I have drawn only the marginal revenue curve corresponding to D-quota. (You may need to go to an elementary microeconomics book and review the section on the monopolist’s marginal revenue curve.) A profit-maximizing firm will choose to produce where marginal revenue equals marginal cost, at Qxq, but can charge a price appropriate to his demand curve. In this case, he can charge Pq. At price Pq, domestic production equals Qxq, while consumption equals Qxt. (It is a coincidence that this equals production with the tariff.) Note that at price Pq, domestic production, Qxq and imports (Qxt - Qxq) will just satisfy demand.

The homework problem did not ask you to analyze the welfare changes. (And I will not put this particularly difficult welfare cost puzzle on the third exam!) In the movement from free trade to the tariff, the government gained the tariff revenue (light blue rectangle) and the monopolist gained turquoise and aqua areas between Pw and Pt. When the tariff was changed to a quota, the government lost the tariff revenue while the monopolist added the gray area to its producer surplus (although it did lose the aqua area between Pw and Pt and the rose triangle below it). 

The quota rent is shown as the entire aqua rectangle (including the blue triangle in its lower right corner) . If the quota rights were given to the foreign suppliers, then they gained all the quota rent, which you should note is substantially larger than the tariff revenues. Why? Foreign suppliers will not keep their prices at P, when they are assured of receiving Pq for all their imports.

The consumption and production deadweight costs associated with the tariff are shown as the medium blue triangles. The production deadweight cost with the quota is shown as the rose triangle below the Pw line. The consumption deadweight cost with the quota is the sum of the rose triangle above the Pt line, and the light and medium blue areas between Pt and Pw lines and between Qxt and Qc

 

5. The United States has used quotas to protect its domestic sugar industry. What has been the likely impact of these quotas on the world price of sugar (relative to the price that would exist under free trade)? Explain.

The quotas had the predictable impact on the US sugar market: prices increased and consumption decreased. But the question asks about the world price of sugar. The sugar that the quota eliminated from the US market was subsequently diverted to the world market, and the world price of sugar fell. The US State Department pointed out that those countries (nearly all developing countries) that have a portion of the US sugar quota receive a premium over the world price, and argued that it is a form of "free" foreign assistance. However, studies of the impact of sugar barriers of OECD countries (of which the United States has the most trade-restrictive) estimate that in 1983 liberalization would have raised foreign exchange earnings of developing country exporters by as much as $7 billion and provided net welfare gains of up to $2 billion.

6. Is the optimum tariff argument a valid argument for protection? Is it the best policy for these purposes? Explain.

When a country has sufficient market power, it may be possible to impose an import tariff and improve domestic welfare. This occurs because the country’s action affects the perceived demand for the good on the world market and forces the importers to lower the world price. In this case, the government gains tariff revenue while minimizing the deadweight loss—the optimal tariff maximizes the sum of the two. (But what happens to world welfare? Is the welfare loss in the producing country compensated by gains in the importing country?) The optimum tariff argument is thus a valid argument for protection. Despite its validity, it is also clear that an optimal tariff is not the best way to improve a country’s economic well being. For instance, a side payment from the exporting country combined with a promise of free trade can be shown to raise welfare more in the tariff imposing country and generate lower losses to the exporting country. Such a side payment is unlikely, however, due to political considerations. If, instead, the tariff leads to retaliation, then there is a high probability that welfare will fall.

7. Consider the example of strategic trade policy described in the text. Suppose that the United States matched Europe’s export subsidy with a subsidy of 10 to Boeing. How would this policy affect the solution to the game? What would be the welfare effects of this policy on America and Europe?

If the United States matches the European subsidy and there is no further escalation of subsidies, the payoff matrix will look as follows (note that the first number in each ordered pair is the payoff to Boeing, while the second number is the payoff to Airbus).

 Payoff matrix with US and European subsidies of 10 Airbus
produce not produce
Boeing Produce 5, 5 110, 0
Not Produce 0, 110 0, 0

By matching the foreign subsidy, the U.S. government hopes to return to Boeing whatever advantage it originally had. (As described in the text, Boeing had a head start, but note that Airbus could not enter profitably if Boeing was already producing.) If Airbus does not produce as a result of the subsidy that Boeing received, U.S. welfare increases and European welfare falls. The entire subsidy competition between the nations raises Boeing’s profits at the expense of U.S. taxpayers. Alternatively, both companies may produce, each earning a small profit due to the subsidies they receive, but there would be no net gain from this attempt at strategic trade policy if it ends in a standoff.

 Original payoff matrix with no subsidies  Airbus
produce not produce
Boeing Produce -5, -5 100, 0
Not Produce 0,100 0,0

 

8. The United States has recently begun building a new type of television called high definition television (HDTV). Should the U.S. impose temporary protection to guarantee U.S. commercial success in this product? Why or why not?

The issue at hand is whether a case for supporting domestic HDTV producers can be made similar to the infant industry argument, the domestic distortions argument (where the distortion arises from technological spillovers to other industries), or the strategic trade policy argument. If students proceed along any of these lines then they should apply for jobs at the U.S. Department of Commerce or the U.S. Trade Representative’s Office. Although most students offered legitimate arguments, one pointed out that these are established companies, so the infant industry argument may not apply. Another reminded us that a production subsidy would be a more efficient way to encourage domestic production when compared to a tariff or a quota. A third student added that any protection selected should be temporary.

9. Suppose that the domestic demand and supply for hats in a small open economy are given by:

Q = 100 - P (demand)

Q = 50 + 2P (supply)

Where Q denotes quantity and P denotes price.

a) If the world price is 10 what is the free trade level of imports?

To find trade, substitute P=$10 into the two equations. Demand equals 90 and domestic supply equals 70. At a price of $10, excess demand, imports, would be 20.

b) Suppose that the country imposes a quota of 11 units, how much will the domestic price rise?

To find this price, set excess demand (M=Qd - Qs) equal to 11 and solve for P.

Imports, 11 = (100 - P) - (50 + 2P)

3P = 100 - 50 - 11 = 39.

P = 13. Thus price rises by 3.

c) What will be the welfare effects on this country of a quota of 11 units?

The welfare effects include the deadweight costs and (possibly) the quota rents.

Deadweight costs = 0.5*equivalent tariff * change in imports

= 0.5*3*(20-11) = 13.5

The quota rents = equivalent tariff * imports = 3*11 = 33.

The (static) welfare cost is, at best, 13.5, if the quota rents are captured by the importing country and not wasted on rent seeking. At worst, the static welfare loss is as much as 46.5, if all the quota rents are given to a foreign country or spent on rent-seeking activities. Of course, if demand grows, or if there is domestic monopoly power, then the losses under the quota are even higher.

d) Suppose instead that this country negotiates a VER of 11 units with its chief foreign supplier. What are the welfare effects of this policy?

The welfare effects of the VER include the deadweight costs and all of the quota rents or 46.5

10. According to the analysis in this chapter, VERs are a more costly form of protection than tariffs or other types of quotas. Why do countries like the United States continue to protect certain industries using this form of protection?

VERs continue to be used for several of the following reasons. First, as with most NTBs, it is hard for consumers to associate increases in product prices with the policy that has been reached. Second, until recently, VERs have allowed governments to impose quotas that circumvent older GATT proscriptions on such policies. However, the WTO now imposes some limits on the use of VERS; the Uruguay Round agreement states that VERs will be phased out by the year 2000. Finally, because the policy affords some compensation to the countries whose goods are restricted, policy makers may be less reluctant to impose these barriers.

11. Suppose that Guatland protects its motorcycle industry with a quota that raises domestic prices by $100 per unit. If Guatland’s government were to then impose a tariff of $90 per motorcycle, what would happen to Guat motorcycle imports? What would be the welfare effects of this tariff on the Guat economy?

Nothing should happen to the price of motorcycles. The tariff is less restrictive than the preexisting quota, as shown by the red line below; it serves merely to redistribute quota rents from importers to the government. As such, there is no effect on Guat welfare, unless the quota rents were lost to Guat under the quota.

12. Under what circumstances can commercial policy be an effective tool to solve world environmental problems? Under what circumstances will commercial policy not be very effective? In general, which set of circumstances are more likely to exist in the real world?

Commercial policy would be most effective in those cases where the country that imposes the policy is the primary purchaser of the product whose production is responsible for the environmental problems. In this case, trade barriers could reduce the world price, and reduce foreign production (and hence pollution). This situation is, in effect, symmetric to the optimal tariff argument. Even in this case, however, protection could lead to increased production of the product in the home country. Hence, it may be necessary to supplement protection with local environmental taxes—indeed that may be the only WTO legal measure. If these conditions do not hold, as is most often the case, then commercial policy will have little or no positive effect on the environment.

Back to top