Tariffs and Quotas

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.

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.

Effects of Tariffs on International Trade

Market 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).

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).

Market equilibrium with a quota, StudySmarter Original

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.