Tariffs and quotas are two major methods of protection generally used by the trading countries in their commercial policies. Tariff is a tax or duty on imports, whereas quota is a quantitative restriction on imports. While quotas restrict the imports directly, tariffs do so indirectly by raising the prices of imports.
Various effects of tariffs and quotas are discussed below:
Economic Significance of Tariffs:
A tariff is a tax on imports. The economic significance of a tariff is that- (a) tariff causes the domestic price of the imported goods exceed its foreign price, or, in other words, the price a domestic purchaser pays for an imported good exceeds the amount the foreign exporter receives by the tariff payment; and (b) tariff causes the domestic relative price of imports in terms of exports to exceed the foreign relative price or terms of trade. All other economic effects of tariff follow from these basic facts about tariffs.
These facts are further classified below:
(i) If the tariff is a specific tariff, i.e., a fixed duty imposed on each unit of imported good, then the domestic price of the imported good (Qm) is equal to foreign price (Pm) plus specific tariff (ta).
Qm = Pm + ta … (1)
(ii) If the tariff is an ad valorem tariff, i.e., the tax levied as a percentage of the price of the imported good, then the domestic price of the imported good (Qm) consists of the price paid to the foreigner (pm) plus the ad valorem tariff rate (ta).
Qm = Pm (1 + ta) … (2)
(iii) If we suppose- (a) that Pm is the domestic price and t is a uniform ad Valorem tariff; (b) that the exports are not taxed so that the price (i.e., px) that the foreigners pay for our exports equals the price (i.e., Qx) received by the domestic exports (i.e., Px = Qx); and (c) that q = Qm/Qx stands for domestic relative price of imports in terms of exports, and p = Pm/Px stands for foreign relative price or terms of trade, then Equation (2) can be improved to define the domestic relative price of imports in terms of exports (q = Qm/Qx) as-
which indicated that a tariff causes the domestic relative price of imports in terms of exports (q = Qm/Qx) to exceed the foreign relative price in terms of trade (p = Pm/Px)
(iv) Equation (3) further implies that-
i. e., the tariff rate (t) equal the percentage by which q exceeds p.
Overall Impact of Tariff on World Economy:
The application of the theory of comparative advantage explains that tariffs are inefficient for the world as a whole. They cause the production and consumption levels of the world as a whole to fall.
1. Effect on World Production:
Tariff causes the domestic relative price of imports in terms of exports (q) to exceed the foreign relative price (p). The fact q > p means that the marginal rate of transformation of exportable for importable (MRTxm) is greater at home.
In other words, more exports must be sacrificed to produce one more importable at home than abroad. This further implies that the world can produce more of either of both goods if (a) the home country shifts its resources from producing importable; (b) the rest of the world does the opposite; and (c) international trade increases.
2. Effect on World Consumption:
Tariff causes the domestic relative price of imports in terms of exports to exceed the foreign relative price (i.e., q > p). This means that the marginal rate of substitution of exports (MRSxm) of each domestic consumer exceeds marginal rate of substitution of exports for imports of each foreign consumer.
In other words, each domestic consumer is willing to sacrifice more of exports to obtain one more import than each foreign consumer would require supplying it. Thus, the consumers in both the countries can be made to increase their consumption levels by trading more.
The conclusion that tariffs are inefficient for the world as a whole does not mean that it is not beneficial to the imposing country. The truth is that the tariff imposing country receives both favourable and unfavourable effects through the imposition of a tariff and it is also likely that the favourable effects outweigh the unfavourable effects.
But, the important implication of overall harmful effect of tariff on the world economy is that if a country gains from a tariff, it is at the expense of the rest of the world.
Effects of Tariffs on the Imposing Country:
Kindleberger has discussed eight effects of tariff on the imposing country-(a) protective effect; (b) consumption effect; (c) revenue effect; (d) redistribution effect; (e) terms of trade effect; (f) income effect; (g) balance of payment effect; and (h) competitive effect. In words of Kindleberger, a tariff “is likely to alter trade, price, output, consumption, and to reallocate resources, change factor proportions, redistribute income, change employment and alter the balance of payments.”
All these effects of tariffs are discussed below:
(a) Protective Effect:
A tariff has protective effect for the domestic industries. It tends to raise the domestic price of the imported commodity, reduce the domestic demand for that commodity and thereby stimulates its domestic production. In Figure 2, DD and SS are the domestic demand and supply curves of the commodity in question. In the absence of trade, the equilibrium is at point E, the price is OP3 and country’s production and consumption is P3E.
Under free trade conditions, Sd+f becomes the supply curve which includes both domestic and foreign supply. Foreign supply is assumed to be perfectly elastic. Equilibrium is at point T and the price is OP1. At this price, quantity OQ2 is demanded, of which OQ1 is produced at home and the rest Q1Q2 is imported.
Now the government imposes a tariff equal to the amount P1P2, thus shifting the supply curve to Sd+f+t and raising the price to OP2. As a result, the quantity demanded falls from OQ2 to OQ4, the quantity produced at home increases from OQ1 to OQ3 and the quantity imported reduces from Q1Q2 to Q3Q4. In this case, the protective effect (which is another name for production effect) is Q1Q3.
(b) Consumption Effect:
Imposition of tariff raises the price, and as a result, the demand for the commodity falls. Total outlay on consumption of the commodity is larger or smaller depending upon whether demand is inelastic or elastic. In Figure 2, before the imposition of tariff, the consumers demand OQ2 at price OP1, with the imposition of tariff (i. e., P1P2), the price rises from OP1 to OP2 and the quantity demanded falls from OQ2 to OQ4. Thus, Q4Q2 is the consumption effect.
(c) Revenue Effect:
Tariff brings revenue to the government. The revenue to the government is equal to the amount of the import duty multiplied by the quantity of imports. In Figure 2, the revenue effect is P1P2 X Q3Q4 = KLMN.
(d) Redistribution Effect:
Redistribution Effect refers to the transfer of real income from the consumers to the producers as a result of tariff. The tariff-imposed price increase (from OP1 to OP2) results in the loss of consumer’s surplus equal to the amount P1P2LT. Of the total loss suffered by the consumers, P1P2 KR amount is transferred to the domestic producers. This is the redistribution effect. KLMN amount is transferred to the government as tariff revenue.
The loss of consumers surplus represented by the triangles KRM and LNT is transferred neither to the producers nor to the government; KRM + LNT represent the total net real loss to the economy as a result of tariff. KRM is the net real loss suffered by the society due to inefficient use of the resources; increased output (i.e., Q1Q3) as a result of the tariff is possible by diverting factors of production from other sectors of the economy at higher cost (as represented by the rising supply curve). LNT is the net real loss due to the reduction in consumption (i.e, Q4Q2).
The above discussed effects of tariff (in Figure 2) can be summarises below:
1. Tariff imposed- P1P2.
2. Effect on price- from OP1 to OP2, i.e., P1P2.
3. Effect on imports- from Q1Q2 to Q3Q4
4. Protective effect- from OQ1 to OQ3, i.e. Q1Q3.
5. Consumption effect- from OQ2 to OQ4 i.e., Q4Q2.
6: Revenue effect- KLMN
7. Redistribution effect- P1P2KR
8. Real loss on production- KRM
9. Real loss on consumption- LNT
10. Total real cost of tariff- KRM + LNT
(e) Terms of Trade Effect:
When a country imposes a tariff duty, its willingness to receive imports is reduced. For a given quantity of exports, the country now demands a larger quantity of imports because a part of these imports are to be surrendered to the customs authorities in the form of tariff payment.
Or, putting the same thing differently, the country is now willing to offer less of exports in exchange for a given quantity of imports. Thus, the tariff reduces the country’s offer of exports for imports. In diagrammatic terms, the tariff shifts the country’s offer curve to the left. This increases the country’s terms of trade or the rate at which exports are exchanged for imports.
In Figure 3, OH and OF are the offer curves of country H (i.e., home country) and country F (i.e., foreign country) respectively. Under free trade conditions, the two countries are in equilibrium at point E where their respective offer curves intersect. The terms of trade is given by the slope of line OT. Country H is exporting OW wheat and importing OC cloth from country F. Now suppose the country H imposes a tariff on imports of cloth from country F. As a result, the offer curve of country H will shift from OH to OH’.
The new equilibrium is at point E’ and the new terms of trade is given by the slope of line OT’. Now, the country H exports OW1 of wheat in exchange for OC1 of cloth from country F. The change in the terms of trade (i.e., from OT to OT’), as a result of the imposition of tariff, is in favour of country H because it now offers less of its wheat in exchange for a certain quantity of country F’s cloth. The fall in imports from country F (i.e. CC1) is less than the fall in exports from country H (i.e., WW1).
The extent of improvement in the terms of trade of the tariff- imposing country depends upon- (a) the elasticity’s of foreign offer curve and (b) retaliation from other countries.
(i) Effect of Different Elasticity’s of Foreign offer Curves:
The extent of improvement in the terms of trade of the tariff-imposing country depends upon the shape of the other country’s offer curve. If the foreign offer curve is perfectly elastic, no tariff will bring the home country improved terms of trade; the terms of trade will not be affected at all. The less elastic the foreign country’s offer curve, the more a given tariff will improve the home country’s terms of trade.
In figure 4, there are three foreign curves with different elasticity’s, i.e., OF1 (perfectly elastic), OF2 (less elastic) and OF3 (still less elastic). The tariff-induced shift in the home country’s offer curve (i.e., from OH to OH1) produces equilibrium levels (E1, E2 and E3) which show increasingly favourable terms of trade (OT1, OT2 and OT3) for the home country.
Perfectly elastic offer curve (OF1) is identical to the free-trade terms of line (OT1). The tariff has no impact on the terms of trade; the terms of trade at E1 (when tariff is imposed) are the same as they were at E (when there was no tariff).
(ii) Effect of Retaliation:
If one country imposes a tariff and there is no retaliation by the other country, the terms of trade changes in favour of tariff-imposing country and it gains at the expense of its trading partner. But, if the other country retaliates and if this leads to counter-retaliation, and there starts a tariff war between the two countries, then the final effect of tariff on terms of trade will depend upon the relative size of the tariffs.
But, one thing is certain. As a result of retaliation and counter-retaliation, the volume of trade declines and both the countries lose. The initial equilibrium in Figure 5 is at E where the offer curves of home country (OH) and foreign country (OF) intersect each other. The terms of trade is given by the slope of the line OT.
After the process of retaliation and counter-relation, the equilibrium level E2 is reached, where the ultimate tariff- distorted offer curves of both the countries (OH2 and OF2) intersect in such a way that, from the terms of trade point of view, no country is loser.
The terms of trade remains the same (OE2 = OE = OT). The only effect of retaliation is the decline in the volume of trade (i.e., from OW + OC to OW1 + OC1).
(iii) Smaller Nations and Threat of Retaliation:
Imposition of tariff in one country leads to retaliation by the other country. But, if the country that imposes tariff on its imports is a small and economically insignificant, it can easily improve its terms of trade without facing any threat of retaliation.
The reason is that the small country has a very limited market for the exports of other countries and any reduction of exports to this country as a result of the latter’s adoption of tariff policy will be very small. Thus, the smaller a country, the less likely it is that the other countries will retaliate against its tariff policy and more easy for it to improve its terms of trade by imposing import duty.
(f) Balance of Payments Effect:
Tariff has favourable effect on the balance of payments position of the imposing country. It reduces imports and increases the export surplus of the country. Thus, through tariffs, a deficit in the balance of payment can be corrected.
(g) Income Effect:
As a result of tariff, the expenditure on imported goods is reduced. This will increase the export surplus of the country and thereby the income from foreign trade. The money shifted from imports can now be spent on the domestically produced goods. If the country is at less than-M employment level, this will raise income and employment in the country.
(h) Competitive Effect:
Tariff protects the domestic industry from foreign competition. Under this protection an infant industry after a period of time, grows into an economically strong industry which can fully compete in the world market. But, the sluggish and lazy industry may not like to face the competition and remain inefficient even under the protection cover provided through tariffs.
Various effects of the fixation of quota of an imported commodity are explained below:
1. Price Effect:
When the quota of an imported commodity is fixed, its imports fall and price rises. The actual effect of quota on price will depend upon the elasticity of demand and supply. In Figure 6, DD and SS are demand and supply curves. Under free trade, the price of the commodity is OP1.
At this price, the domestic demand for the commodity is OQ2, but the domestic supply is OQ1. Thus, Q1Q2 amount is imported. When import quota is imposed, the imports are reduced and fixed at Q3Q4 amount. As a result of reduction in imports from Q1Q2 to Q3Q4, the imports price rises from OP1 to OP2. Thus P1P2 is the price effect.
2. Protective Effect:
Fixation of import quota leads to the reduction in imports and increase in import price. This increases the domestic production and gives the home producers protection against foreign competition. When Q3Q4 import quota is fixed, domestic production increases from OQ1 to OQ3. Thus, Q1Q3 is the protective effect of the import quota.
3. Consumption Effect:
When import price rises on account of the import quota, domestic consumption and hence the welfare declines. An import quota of Q3Q4 raises the price from OP1 to OP2 and reduces the domestic consumption form OQ2 to OQ4. In this case, Q4Q2 decline in consumption is the consumption effect of the import quota.
4. Revenue Effect:
The revenue effect of import quota is uncertain. The fixation of import quota (Q3Q4) raises the import price (by P1P2) and therefore yields revenue (P1P2 X Q3Q4=KLMN) which may go the government or may be divided among the domestic importers and foreign exporters.
The division of revenue among importers and exporters depends upon the market structures prevailing among these two groups:
(a) If the government auctions the import licences, this revenue will be, like the tariff revenue, earned by the government.
(b) If the foreign supply is perfectly elastic (as is assumed in Figure 6), and if the government does not sell licences, then the revenue will go to the importers,
(c) If the government does not sell licence, but the exporters are able to raise delivered prices, then the revenue will be taken away by the exporters.
5. Redistributive Effect:
Import quota also has distributive effect by transferring real income from the consumers to the producers. The rise in price (from OP1 to OP2) as a result of import quota leads to the loss of consumer surplus as represented by P1P2 LT.
Of this total consumer surplus, P1P2 KR amount is the redistributive effect because it is earned by the producers as profit. The loss of consumer surplus as represented by the areas KRM and LNT are considered the cost of the quota in terms of decreased productive efficiency and consumer satisfaction respectively.
6. Terms of Trade Effect:
Imposition of import quota generally results in a change in terms of trade in favour of the quota fixing country. This is shown in Figure 7.
In Figure 7, OH and OF are the free trade offer curves for the home (H) and foreign (F) countries respectively. OT is the terms of trade line. The initial equilibrium is at point E which shows that the country H exports OW of wheat in return for OC of cloth from country F. If country H fixes a quota of OC1 amount on the imports of cloth from country F, the country H’s offer curve becomes OSC1 which shows that its offer of wheat becomes zero
when the imports reach the amount of quota.
OSC1 curve intersects the country F’s offer curve OF at E1; and OT1 is the new terms of trade. Thus, the terms of trade under the quota system (OT1) is an improvement over the free trade terms of trade (OT). The extent of improvement in terms of trade however depends upon the shape of foreign country’s offer curve and the retaliatory action.
The gain from the imposition of quota can be measured (in terms of wheat) as the quantity W1 W2. It is not certain how this gain will be distributed- (a) If there is competitive bidding for import licenses, this gain will go the government. (b) If the exporters in the foreign country and the home importers compete freely among themselves, this gain will go to the foreign exporters, (c) If there is collision among the importers and exporters compete freely, the home importers will capture the gain, (d) if there is collusion among both exporters and importers, the distribution of gain will depend upon the relative bargaining strength of the two parties.
7. Balance of Payment Effect:
Quotas restrict imports and thus help in correcting the adverse balance of payments. In this regard, quota is more effective than tariff because the former has direct impact on checking imports.
8. Income Effect:
Quota is also superior to tariff in its impact on income and employment. Quota reduces imports without leakages. The money thus saved can be spent on domestically produced goods. This will increase income and employment in the country.
Tariffs impose a monetary charge on imports but permit an unlimited quantity of goods to enter the country as long as the import duty is paid. Quotas, on the other hand, put quantitative restrictions on imports and permit only a strictly limited quantity of goods to enter the country.
Although the effect of these two methods of protection are almost similar, but both the methods are useful in different conditions. In some cases, quotas are superior to tariffs, but in other tariffs are more effective than the quotes. Both these views are examined below:
(i) As compared to tariffs, quotas are more precise in nature and more certain in effect.
(ii) Quotas are more popular and less resented by the trading nations than tariffs.
(iii) Quotas are preferred in the situations where domestic demand for the imported commodity is inelastic.
(iv) Quotas also have a strong case under the conditions of highly inelastic foreign supply.
(v) Quotas are administratively more flexible instruments of commercial policy than tariffs. Quotas can be more easily imposed and more easily removed. Tariffs, on the other hand, are relatively permanent measure and are more difficult to remove.
(vi) Quotas prove more useful in those situation where the domestic consumers and foreign exporters are needed to be checked effectively, i.e., (a) when the country is facing foreign exchange problem; (b) when the country is passing through a period of economic distress and wants to check the outflow of domestic income by imports; (c) when there is deflation abroad and the foreign exporters want to transmit this deflation to the importing country by stimulating exports.
(i) Quotas are more arbitrary than tariffs. They are granted on a selective or discriminatory basis and distort the pattern of international trade by interfering in the operation of the price system and market forces,
(ii) Quotas tend to develop monopolies of importers and exporters. The administrative allocation of quotas to importers reduces competition and leads to the development of import monopolies. Similarly, quotas tend to promote concentration among foreign exporters in order to bargain effectively with the home country’s importers.
(iii) Quotas are too restrictive and generally lead to retaliatory action by other countries,
(iv) Under the quota system, the government suffers a loss of revenue which it can get under the tariff system.
(v) Quota system gives too much power to the administrative officials and thus may encourage the evils of corruption and favouritism.