Quotas

Some people are familiar with the term "quota" and its general definition but that's about it. Did you know there are different types of quotas? Have you ever wondered what impact quotas have on the economy? Can you explain the differences between a quota and a tariff? These are just some of the questions that this explanation will answer. We will also go over some examples of quotas and the disadvantages of setting quotas. If that sounds interesting to you, stick around, and let's get started!

Quota Definition in Economics

Let's start with the quota definition in economics. Quotas are a form of regulation that is usually set in place by the government to limit the quantity of a good. Quotas can be used to regulate prices and restrict the amount of international trade in an economy.

Quotas are a type of protectionism meant to keep prices from falling too low or rising too high. If the price of a good falls too low it becomes difficult for producers to remain competitive and might force them out of business. If the price is too high, consumers will not be able to afford it. A quota can be used to regulate or restrict trade by limiting the number of imports and exports of a certain good. Quotas can also be used to limit the production of a good. By regulating the quantity produced, the government can influence the price level.

Since quotas interfere with a market's natural level of price, demand, and production, they are often seen as hurting trade and the economy even if domestic producers enjoy higher prices. Much like a price floor, the quota prevents the market from reaching its natural equilibrium by keeping domestic prices above the global market price. This creates deadweight loss, or net efficiency loss, which is the combined loss of consumer and producer surplus due to the misallocation of resources.

The government may choose to set a quota for several reasons.

1. To limit the amount of a good that can be imported
2. To limit the amount of a good that can be exported
3. To limit the amount of a good produced
4. To limit the amount of a resource being harvested

There are different types of quotas to achieve these different results.

Types of Quotas

A government may choose from several types of quotas to accomplish different results. An import quota will limit the amount of a good that can be imported while a production quota can limit the quantity produced.

Table 1 shows three main types of quotas, however, there are many more types of quotas depending on the industry. For example, fisheries are an industry that is often subject to the limits set by quotas as a way of protecting fish populations. These types of quotas are called Individual Transferable Quotas (ITQ) and are distributed in the form of quota shares that give the shareholder the privilege to catch their specified portion of that year's total catch.¹

Production Quota

A production quota can be set by a government or organization and set on a country, industry, or firm. A production quota can both increase or decrease the price of a good. Limiting the quantity of the goods produced drives prices up, while setting higher production goals will put downward pressure on prices.

When quotas limit production, pressure is put on consumers and causes some of them to be priced out of the market resulting in deadweight loss.

Fig. 1 - Effect of a production quota on price and supply

Figure 1 shows when a production quota is set and reduces the supply of a good by shifting the curve from S to S₁, the price increases from P₀ to P₁. The supply curve also changes from an elastic state to a perfectly inelastic state which results in a deadweight loss (DWL). The producers benefit by gaining the producer surplus from P₀ to P₁ at the cost of consumer surplus.

Import Quota

An import quota will limit the amount of a certain good that can be imported. By placing this restriction, the government can prevent the domestic market from being flooded with cheaper foreign goods. This protects domestic producers from having to lower their prices to remain competitive with foreign producers. However, while domestic producers whose products are covered by the quotas benefit from the higher prices, the cost of the import quota to the economy in the form of higher prices is consistently greater than the benefit to the producer.

Fig. 2 - An Import Quota Regime

Figure 2 shows the effect of an import quota on the domestic economy. Before the import quota, domestic producers produced up to Q₁ and imports satisfied the rest of domestic demand from Q₁ to Q₄. After the quota is set, the number of imports is limited to Q₂ to Q₃. This increases domestic production up to Q₂. However, since supply is now reduced the price of the goods increases from P₀ to P₁.

Two Main Types of Import Quotas

A government may choose to implement a tariff-rate quota over an absolute quota because with the tariff-rate quota they earn tax revenue.

An export quota is a limit on the amount of a good that can be exported out of a country. A government might elect to do this to support the domestic supply of goods and control prices. By keeping domestic supply higher, domestic prices can be kept lower, benefiting consumers. The producers end up earning less since they are forced to accept the lower prices and the economy suffers reduced export revenue.

Difference Between Quotas and Tariffs

What exactly is the difference between quotas and tariffs? Well, where a quota limits the number of goods available, a tariff does not. Quotas also do not generate revenue for the government while a tariff makes people pay taxes on the goods they import. A tariff is also only applied to imported goods whereas quotas can be found in other parts of the economy.

We cannot say that quotas do not generate any revenue at all. When quotas are put in place, the price of the goods rises. This increase in the revenue that foreign producers earn as a result of the higher prices after a quota has been set is called quota rent.

When the goal is to reduce the number of goods in a market, a quota is a more effective route since it caps the quantity of a good available by limiting its production, imports, or exports. In this case, tariffs serve as more discouragement to consumers from buying the goods since they are the ones who pay the higher price. If a government is looking to earn revenue from a good, they implement tariffs, because the importing party must pay the tariff to the government when they are bringing the goods into the country. However, to avoid reduced profits, the importing party will increase the sales price of the goods by the amount of the tariff.

In terms of protecting domestic industries, quotas are a better option than tariffs since import quotas are a more reliable method of actually reducing competition with imported goods.

In the end, both quotas and tariffs are protectionist measures that reduce the number of goods in a market and cause domestic consumers to experience price increases. The higher prices result in some consumers being priced out of the market and produce a deadweight loss.

Examples of Quotas

It's time to look at some examples of quotas. If you are not the one doing the producing, importing, or exporting, quotas can sometimes fly right over our heads. As a population, we are used to inflation and taxes causing prices to rise, so let's see how a production quota might push prices up.

An example of a production quota limiting production would look like this example.

An example of an import quota would be the government restricting the number of oranges that can be imported.

An export quota prevents goods from leaving a country and reduces domestic prices.

Disadvantages of Quota System

Let's group the disadvantages of a quota system. Quotas can seem beneficial at first but if we take a closer look, we can see that they overwhelmingly limit the development and growth of an economy.

Quotas are meant to regulate domestic prices. Import quotas keep domestic prices high to benefit the domestic producer, but these high prices come at the cost of the domestic consumer who must also pay the higher prices. These high prices also reduce the overall level of trade a country engages in because foreign consumers will reduce the number of goods they buy if prices rise, which reduces the country's exports. The gains that producers make typically do not exceed the cost to consumers of these quotas.

These import quotas also do not earn the government any money. The quota rents go to foreign producers who sell their goods on the domestic market at a higher price. The government gains nothing. A tariff would increase prices as well but would at least benefit the government so that it could increase spending in other sectors of the economy.

Export quotas have the opposite effect of import quotas, except that they also do not benefit the government. Doing the opposite of import quotas does not make them less limiting to the economy as a whole. Where they benefit consumers by lowering the price of a good, we sacrifice the potential revenue producers could have made and then reinvest into their business.

When a quota limits the production of a good, it is both the consumer and producer that suffer. The resulting increase in prices negatively impacts the consumer, while the producer loses out on potential revenue by producing under their maximum or desired output level.