Most countries of the world impose restrictions on imports. Two main instruments of import control are tariffs and quotas. Both keep the domestic price of an imported item above world levels and thereby enable the domestic industries to enjoy the benefits of higher price and larger profits than would be possible under free trade.
However, the cost to society from this protection can be quite high because the gain to domestic producers is more than offset by the loss to consumers.
Under free trade a country will import a good if its world price is less than its domestic price in the absence of imports. This point is illustrated in Fig. 2.30. In the absence of imports, the domestic price and quantity would be P0 and Q0 which equate supply and demand. But if the world price Pw is below P0, domestic consumers will be eager to import the commodity if imports are not banned or restricted.
In Fig. 2.30 Qs, Qd is the volume of imports at the world price Pw. It is the difference between domestic production Qs and domestic consumption Qd. Imports are positive because at the lower price, domestic production will fall to Qs and domestic consumption will rise to Qd.
Now let us suppose the government stops the import of the commodity altogether by imposing an import quota. How will this affect the producers and consumers?
As soon as imports are stopped the domestic price will rise to Pd in Fig. 2.30. Consumers will now buy Q0 units and pay the domestic price Pd. Here price rise leads to a fall in consumers’ surplus measured by two areas — trapezoid A and triangle B. Moreover, some consumers will no longer be able to buy the commodity. So there is an additional loss of consumers’ surplus measured by the triangle C.
So the total loss of consumers’ surplus is:
∆CS = – A – B – C
In contrast, producers gain. Since production increases (Q0 > Qs) under the impetus of higher price (Pd > Pw) producers’ surplus increases by the area A: ∆PS = A. The change in total surplus, ∆CS + ∆PS is, therefore -B-C. Since consumers lose more than producers gain there is a deadweight loss. Imports can also be eliminated altogether by imposing a prohibitive tariff.
The tariff has to be at least equal to, if not greater than, the difference between P0 and Pw. Since there is no revenue from such a high tariff, the effect of this tariff will be the same as that of prohibitive import quota.
In general the objective of any government policy is to reduce and not to eliminate imports altogether. Fig. 2.31 shows that this can be done with either a tariff or a quota. Under free trade, the domestic price will equal the world price Pw, and imports will be Qd – Qs.
Now if a tariff of T rupees per unit is imposed on imports the domestic price will rise to (P* = Pw + T). This will lead to a rise in domestic production and a fall in domestic consumption.
In Fig. 2.32 this tariff leads to the following change of consumers’ surplus ∆CS = -A-B-C-D. The change in producers’ surplus is the same as in Fig. 2.31, i.e., ∆PS = A. Finally the revenue of the government is given by the rectangle D which is the amount of tariff multiplied by the quantity of imports. The total change in welfare, ∆CS plus ∆PS plus the revenue to the government, is therefore -A-B-C-D + A + D = -B-C.
So triangles B and C measure the deadweight loss from import tariffs. Here the triangle B represents loss from domestic overproduction and C the loss from under consumption. Thus import tariff leads to domestic distortions and inevitably involves welfare loss to society.
If the tariff is replaced by an import quota (which restricts the volume or the value of imports), foreign producers will be permitted to export a specific quantity such as (Qd – Qs, in Fig. 2.32) to India. Since they cannot sell more than this maximum quantity to India they will charge as much as the traffic will bear, i.e., the maximum price Indian consumers are ready to pay for the limited amount of the imported commodity which is now available to them.
There will be no change in consumers’ and producers’ surplus and there will be no revenue effect also under the quota system. The rectangle D will now be appropriated by foreign producers in the form of higher profits. The country as a whole will even be worse off than it was under the tariff, losing D as well as the bearing the deadweight loss B and C. In other words, the net domestic loss is B + C + D.