Welfare Effects of an Import Quota: Large Country

Suppose for simplicity that there are only two trading countries, one importing and one exporting country. The supply and demand curves for the two countries are shown in the adjoining diagram. P_FT is the free trade equilibrium price. At that price, the excess demand by the importing country equals excess supply by the exporter.

The free trade quantity of imports and exports is shown as the blue line segment on each country's graph. (That's the horizontal distance between the supply and demand curves at the free trade price) Suppose the large importing country implements a binding quota set equal to the length of the red line segment. (That's the horizontal distance between the supply and demand curves at either the higher import price or the lower export price) When a new equilibrium is reached the price in the importing country will rise to the level at which import demand is equal to the quota level. The price in the exporting country will fall until export supply is equal to the quota level.

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

Import Quota Effects on:

Importing Country Consumers - Consumers of the product in the importing country suffer a reduction in well-being as a result of the quota. The increase in the domestic price of both imported goods and the domestic substitutes reduces the amount of 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 experience an increase in well-being as a result of the quota. The increase in the price of their product on the domestic market increases producer surplus in the industry. The price increases 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 () 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 they receive the quota rents. This would imply that these rents should be shifted to the exporting country effects and subtracted from 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 recipients of the quota rents. Assume that the quota rent recipients are domestic residents. The net effect consists of three components: a positive terms of trade effect (G), a negative production distortion (B), and a negative consumption distortion (D). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Because there are both positive and negative elements, the net national welfare effect can be either positive or negative. The interesting result, however, is that it can be positive. This means that a quota implemented by a "large" importing country may raise national welfare.

Generally speaking,

1) whenever a "large" country implements a small restriction on imports, it will raise national welfare.

2) if the quota is too restrictive, national welfare will fall

and 3) there will be a positive quota level that will maximize national welfare.

Click here to learn about the details of optimal quotas.

However, it is also important to note that everyone's welfare does not rise when there is an increase in national welfare. Instead there is a redistribution of income. Producers of the product and recipients of the quota rents will benefit, but consumers will lose. A national welfare increase, then, means that the sum of the gains exceeds the sum of the losses across all individuals in the economy. Economists generally argue that, in this case, compensation from winners to losers can potentially alleviate the redistribution problem.

Click here to learn more about the compensation principle.

Import Quota Effects on:

Exporting Country Consumers - Consumers of the product in the exporting country experience an increase in well-being as a result of the quota. The decrease in their domestic price raises the amount of consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Exporting Country Producers - Producers in the exporting country experience a decrease in well-being as a result of the quota. The decrease in the price of their product in their own market decreases producer surplus in the industry. The price decline also induces a decrease in output, a decrease in employment, and a decrease 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 - There are no quota rent effects in the exporting country as a result of the importer's quota, unless the importing government gives away the quota rights to foreigners. Only in this case would the rents accrue to someone in the exporting country.

Exporting Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers and producers. The net effect consists of three components: a negative terms of trade effect (g), a negative consumption distortion (f), and a negative production distortion (h). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Since all three components are negative, the importer's tariff must result in a reduction in national welfare for the exporting country. However, it is important to note that a redistribution of income occurs, i.e., some groups gain while others lose. In this case the sum of the losses exceeds the sum of the gains.

Import Quota Effects on:

World Welfare - The effect on world welfare is found by summing the national welfare effects in the importing and exporting countries. By noting that the terms of trade gain to the importer is equal to the terms of trade loss to the exporter, the world welfare effect reduces to four components: the importer's negative production distortion (B), the importer's negative consumption distortion (D), the exporter's negative consumption distortion (f), and the exporter's negative production distortion (h). Since each of these is negative, the world welfare effect of the import quota is negative. The sum of the losses in the world exceeds the sum of the gains. In other words, we can say that an import quota results in a reduction in world production and consumption efficiency.

International Trade Theory and Policy - Chapter 90-14: Last Updated on 8/20/04