Price Effects of a Quota: Large Country Case

Suppose Mexico, the importing country in free trade, imposes a binding import quota on wheat. The quota will restrict the flow of wheat across the border. As a result, the supply of wheat to the Mexican market will fall and if the price remained the same it would cause excess demand for wheat in the market. The excess demand will induce an increase in the price of wheat. Since wheat is homogeneous and the market is perfectly competitive the price of all wheat sold in Mexico, both Mexican wheat and US imports will rise in price. The higher price will, in turn, reduce demand and increase domestic supply causing a reduction in Mexico's import demand.

The restricted wheat supply to Mexico will shift supply back to the US market. Since Mexico is assumed to be a "large" importer, the supply shifted back to the US market will generate excess supply in the US market at the original price and cause a reduction in the US price. The lower price will, in turn, reduce US supply, raise US demand and cause a reduction in US export supply.

These price effects are identical in direction to the price effects of an import tax, a voluntary export restraint and an export tax.

A new quota equilibrium will be reached when the following two conditions are satisfied.

where is the quantity at which the quota is set, is the price in Mexico after the quota, andis the price in the US after the quota.

The first condition says that the price must change in Mexico such that import demand falls to the quota level . In order for this to occur the price in Mexico rises. The second condition says that the price must change in the US such that export supply falls to the quota level . In order for this to occur the price in the US falls.

The quota equilibrium is depicted graphically on the adjoining graph. The Mexican price of wheat rises from P_FT to which is sufficient to reduce its import demand from Q_FT to . The US price of wheat falls from P_FT to which is sufficient to reduce its export supply also from Q_FT to .

Notice that there is a unique set of prices which satisfies the equilibrium conditions for every potential quota that is set. If the quota were set lower than , the price wedge would rise causing a further increase in the Mexican price and a further decrease in the US price.

At the extreme, if the quota were set equal to zero then the prices in each country would revert to their autarky levels. In this case the quota would prohibit trade.

International Trade Theory and Policy - Chapter 90-12: Last Updated on 8/20/04