Tariffs and Quotas

When you read the words "tariffs and quotas", what comes to your mind first? You may have heard about these in the news during the recent trade wars when the US imposed new tariffs and quotas on imports from other countries. But tariffs and quotas have existed long before Trump's trade wars. In fact, tariffs and quotas are two common forms of trade restrictions. You wonder about how they are different and how they affect the domestic market? Then read on!

Tariffs and Quotas Tariffs and Quotas

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Table of contents

    Tariffs and quotas definition

    Tariffs are taxes on imports. The government often charges tariffs as a percentage of the imports' value, and the tariffs are paid by the importers.

    Quotas are quantity limits of imports. When the government imposes a quota on a product, it tells importers that they can only import up to this amount of that product into the country.

    Difference between tariffs and quotas

    Both tariffs and quotas increase the equilibrium price and decrease the equilibrium quantity in the domestic market, compared to free trade. However, tariffs and quotas work in different ways. Tariffs directly make imported products more expensive by adding a tax on them, and quotas directly reduce the quantity of imports by limiting how many of them can come into the country.

    These two measures also have different implications for government revenue: with tariffs, importers of the taxed products have to make payments to the government; with quotas, no one has to explicitly make a payment to the government - and the importers that get to import the products under the quota system capture this rent. Quotas may also be harder to implement than tariffs, as the government has to constantly monitor the quantity of the imports limited by the quotas.

    With the important difference between tariffs and quotas, we have to be a little careful when we show their effects on a graph. We will show you how to graph them, and this may be important to know for your exams

    Types of tariffs and quotas

    The most common form of tariffs is called ad valorem tariffs: the government charges tariffs as a percentage of the value of the imports. There are other forms of tariffs, and here are a few examples: 1

    • Specific tariffs: tariffs that are based on the physical quantity of the products. For example, the government can charge a $1 tariff per kilogram of cheese.
    • Mixed tariffs: a mixed system where either the ad valorem tariff or the specific tariff applies. For example, the tariff on cheese can be at either $1 per kilogram or 20% of the value, and the government charges the one that results in a higher amount.
    • Compound tariffs: a combination of ad valorem tariffs and specific tariffs. For example, the government can charge a tariff on cheese at $0.50 per kilogram plus 10% of its value.

    The most common form of quotas is called absolute quotas: only a certain quantity of the products can enter the country within the quota period (usually a quarter and sometimes a year). Quota can also take the form of voluntary export restrain, meaning that the exporting country will enforce the quota limits after making an agreement with the importing country. In the US, there are two other types of import quotas: 2

    • Tariff-rate quotas: these allow a certain amount of products to enter the country at a lower tariff rate; after the imported quantity exceeds this amount, the government charges a higher tariff rate.
    • Tariff preference levels: these are established by free trade agreements and other special trade legislations for certain products, and they work in a similar way as tariff-rate quotas.

    Examples of government tariffs and quotas

    A good example of tariffs and quotas comes from the recent trade disputes involving steel and aluminum between the US and other countries. In 2018, in order to protect the domestic industries from foreign imports of steel and aluminum products, the Trump administration imposed a 25 percent tariff on certain steel products and a 10 percent tariff on certain aluminum products.3 These are examples of ad valorem tariffs since they are charged as a percentage of the value of the imports.

    In order to avoid those tariffs, South Korea, Brazil, and Argentina made agreements with the US to impose quotas instead on some of their steel exports based on their average export volumes from the three years before. As a result of these quotas, the amounts of steel that the US imported from these three countries in 2018 dropped significantly from their 2017 levels. 3

    Effects of tariffs and quotas on international trade

    Let's show how tariffs and quotas affect the market equilibrium with graphs - our favorite tool! Here, we are discussing how imposing tariffs and quotas on certain products will affect the domestic market of those products (how they affect domestic producers and consumers of those products). But keep in mind that the effects of tariffs and quotas don't end here. There are domestic producers who rely on imported inputs for their production, and now they face higher prices. Also, the foreign countries will likely choose to retaliate by imposing tariffs or quotas on other goods that our country exports, so our exporters will suffer.

    For a more detailed discussion on these other effects, take a look at our other explanation: International Trade and Public Policy.

    Effects of Tariffs on International Trade

    Tariffs and quotes market equilibrium with tariff | StudySmarterMarket equilibrium with a tariff, StudySmarter Original

    Suppose that the domestic supply and demand curves for car tires look like those in Figure 1. If the country has a closed economy (it does not trade with other countries), the domestic equilibrium would be at Q0 with the price P1, where the domestic supply and demand curves intersect.

    What if the country has complete free trade with the rest of the world? Since there are many producers of tires, the world supply curve is flat at the price Pw. In this case, producers in the rest of the world are able to produce tires at a lower price than the domestic equilibrium price before the country opens up to trade. Under free trade, the new equilibrium is at Q1, where the domestic demand and world supply curves meet. Domestic producers are only able to supply until Qs1, and the producers who are less efficient and need a higher price to sustain their operations would be priced out of the market. The amount of imported tires is ( Q1 - Qs1 ). Consumer surplus is the area below the demand curve and above the price, so with free trade, consumer surplus is the areas of 1, 2, 3, 4, 5, 6, and 7 combined. Domestic producer surplus is the area above the supply curve and below the price. In this case, the domestic producer surplus is only a small area of 8.

    Imagine that the domestic producers of tires will not be very happy with the country opening up to free trade, and they pressure the government to impose a tariff on imported tires to protect the domestic producers. The government decides to impose a tariff amount of t, and this raises the price of imports to Pw+t. Now with this price, the new equilibrium is at Q2. The domestic producers can supply up to the point where their supply curve intersects with the new price at Qs2. The number of imported tires is now ( Q2 - Qs2 ). Compared to the case of free trade, domestic consumers lose areas 1, 2, 3, and 4. Where do they go? Domestic producers gain area 4; the government gets area 2 as the tariff revenue, and areas 1 and 3 are the deadweight loss (decrease in total economic surplus).

    For a discussion on how a country opening up to trade affects equilibrium price and quantity, producer surplus, consumer surplus, and total economic surplus, see our explanation: International Trade and Public Policy.

    Calculations with a numerical example

    Figure 2. is the same graph as Figure 1 but with numbers now. Let's assume that the domestic price for tires without trade is $70, and with this price, domestic consumers will buy 3 million tires per year. If we would have free trade, the domestic price will be equal to the world price for tires at $50, and consumers will buy 5 million of them at this price. In order to protect the domestic tire industry, the government decides to impose a 20% tariff on imported tires (tariff per tire = $50 x 0.20 = $10). The price for tires is now $60 in the domestic market. Can you calculate the change in domestic producer surplus, consumer surplus, deadweight loss, and tariff revenue with the new tariff compared to free trade?

    Tariffs quotes numerical example market equilibrium with tariff | StudySmarterA numerical example of market equilibrium with a tariff, StudySmarter Original

    Increase in domestic producer surplus (area 4) : 12×(2-1)×(60-50) + (60-50) ×1=$15 (million)

    Decrease in consumer surplus (the combined rectangle area of 4, 1, 2 then plus area 3) : 4×60-50+12×(5-4)×60-50=$45 (million)

    Tariff revenue (area 2) : 4-2×(60-50)=$20 (million)

    Deadweight loss (areas 1 and 3) : 12×(2-1)×(60-50)+12×(5-4)×(60-50)=$10 (million)

    Effects of Quotas on International Trade

    Import quotas restrict how many imports of certain products can come into the country. Quotas reduce supply and increase the equilibrium price in the domestic market, compared to the case with free trade.

    It might be easier to understand the effects of a quota with a graph. Look at Figure 3. below, since a quota limits how many products can enter the domestic market, the supply curve shifts to the right by the quota amount. The equilibrium quantity with quota (Q2) is smaller than the free-trade equilibrium quantity (Q1), and the equilibrium price with quota (P2) is higher than the free-trade equilibrium price (Pw). Domestic producers can supply up to the quantity Qs2, which is higher than what they can under free trade (Qs1). The amount of imports under the quota is ( Q2 - Qs2 ). Different from a tariff, the importers don't have to pay the government with a quota. Rather, the importers who get to import the products under the quota can sell the products at a higher price than the world price. This additional revenue is called the quota rent. The quota rent is the green area in Figure 3. Compared to free trade, quotas reduce consumer surplus, increase domestic producer surplus, and reduce total economic surplus (because of deadweight loss).

    Tariffs quotas market equilibrium with quota | StudySmarterMarket equilibrium with a quota, StudySmarter Original

    Tariffs and Quotas - Key takeaways

    • Tariffs and quotas are two common forms of trade restrictions that government imposes to protect domestic producers.
    • Tariffs are taxes on imports; quotas are quantity limits on how many imports can enter the country.
    • Both tariffs and quotas increase the equilibrium price and decrease the equilibrium quantity in the domestic market, compared to free trade.
    • Tariffs generate tariff revenue that goes to the government while quotas generate quota rents that go to the importers who are able to import under the quota.
    • Tariffs and quotas don't just make products more expensive for consumers; they also make it harder for domestic producers who need imported inputs; and, they can also trigger retaliation from other countries.

    Sources:

    1. World Integrated Trade Solution (WITS). "Forms of Import Tariffs." World Bank.

    2. "Quota FAQs." U.S. Customs and Border Protection.

    3. Smith, Holly. "Are quotas worse than tariffs?" Hinrich Foundation.

    Frequently Asked Questions about Tariffs and Quotas

    What are the advantages and disadvantages of tariffs and quotas?

    Tariffs and quotas increase the producer surplus for the domestic producers of those products but reduce the consumer surplus. Tariffs generate revenue for the government while quotas don't.

    What are the effects of tariffs and quotas on international trade?

    Tariffs and quotas increase the equilibrium price and decrease the equilibrium quantity compared to free trade. They may also trigger retaliation from other countries.

    what are quotas and tariffs?

    Tariffs are taxes on imports; quotas are quantity limits on imports.

    What is the difference between a tariff and a quota?

    A tariff makes an import more expensive. A quota reduces the amount of a product that can get in the country.

    What are some examples of tariffs and quotas?

    The Trump administration's 25 percent tariff on some steel products and 10 percent tariff on some aluminum products. In order to avoid those tariffs, South Korea, Brazil, and Argentina made agreements with the US to impose quotas instead on some of their steel exports based on their average export volumes from the three years before.

    Test your knowledge with multiple choice flashcards

    Both tariffs and quotas ______ the equilibrium price and ______ the equilibrium quantity in the domestic market, compared to free trade

    Which of the following statements are correct about the effects of tariffs and quotas?

    A difference between tariffs and quotas is...

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