Welfare Effects of an Import Quota: Small Country

Consider a market in a small importing country that faces an international or world price of P_FT in free trade. The free trade equilibrium is depicted in the adjoining diagram where P_FT is the free trade equilibrium price. At that price, domestic demand is given by D_FT, domestic supply by S_FT and imports by the difference D_FT - S_FT (the blue line in the figure).

Suppose an import quota is set below the free trade level of imports. A reduction in imports will lower the supply on the domestic market and raise the domestic price. In the new equilibrium, the domestic price will rise to the level where import demand equals the value of the quota. Since the country is "small," there will be no effect on the world price which will remain at P_FT.

In the diagram, if the quota is set equal to (the red line segment) then the price will have to rise to P_Q.

The following Table provides a summary of the direction and magnitude of the welfare effects to producers, consumers and the recipients of the quota rents in the importing country. The aggregate national welfare effects is also shown. Online, or with a color print-out, positive welfare effects are shown in black, negative effects in red.

Welfare Effects on:

Importing Country Consumers - Consumers of the product in the importing country are worse-off as a result of the quota. The increase in the domestic price of both imported goods and the domestic substitutes reduces consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Importing Country Producers - Producers in the importing country are better-off as a result of the quota. The increase in the price of their product increases producer surplus in the industry. The price increase also induces an increase in output of existing firms (and perhaps the addition of new firms), an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Quota Rents - Who receives the quota rents depends on how the government

administers the quota.

1) If the government auctions the quota rights for their full price, then the government receives the quota rents. In this case the quota is equivalent to a specific tariff set equal to the difference in prices (t = P_Q - P_FT) shown as the length of the green line segment in the diagram.

2) If the government gives away the quota rights then the quota rents accrue to whomever receives these rights. Typically they would be given to someone in the importing economy which means that the benefits would remain in the domestic economy.

3) If the government gives the quota rights away to foreigners then people in the foreign country receive the quota rents. In this case the rents would not be a part of the importing country effects.

Refer to the Table and Figure to see how the magnitude of the quota rents is represented.

Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the domestic recipients of the quota rents. The net effect consists of two components: a negative production efficiency loss (B), and a negative consumption efficiency loss (D). The two losses together are referred to as "deadweight losses." Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Because there are only negative elements in the national welfare change, the net national welfare effect of a quota must be negative. This means that a quota implemented by a "small" importing country must reduce national welfare.

Generally speaking,

1) whenever a "small" country implements a quota, national welfare falls.

2) the more restrictive the quota, the larger will be the loss in national welfare.

3) the quota causes a redistribution of income. Producers and the recipients of the quota rents gain, while consumers lose.

and

4) because the country is assumed "small," the quota has no effect upon the price in the rest of the world, therefore there are no welfare changes for producers or consumers there. Even though imports are reduced, the related reduction in exports by the rest of the world is assumed to be too small to have a noticeable impact

International Trade Theory and Policy - Chapter 90-16: Last Updated on 8/20/04