Tariffs and quotas
What a tariff or import quota does to prices, producers, consumers and total surplus, and the arguments for and against restricting trade.
FinanceA company's marketAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Work out the gains, losses and deadweight loss of a tariff
- Compare an import quota with a tariff
- Weigh the main arguments for trade restrictions and economists' replies
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 12 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 9
What it is
A tariff is a tax on imported goods. It only matters for a good the country imports.
A tariff raises the domestic price above the world price by the amount of the tariff, for imported and home-made goods. Then:
- Home buyers buy less and pay more: they lose.
- Home producers sell more at a higher price: they gain.
- The government collects revenue on the imports that remain.
- Imports fall, and the market moves back towards its no-trade position.
Buyers' losses exceed the gains to producers plus the government's revenue. The difference is the deadweight loss of the tariff. It has two sources: home firms produce extra units that cost more to make than to buy at the world price, and buyers give up units they valued above the world price.
Import quotas limit the quantity that can be imported. Mankiw's conclusion: quotas are much like tariffs. Both reduce imports, raise the domestic price, hurt buyers, help home producers and cause deadweight losses. The one difference is who gets the extra money: a tariff raises revenue for the government; a quota gives the surplus to whoever holds the import licences, which may be foreign firms.
Quick check
Tap an answer to check it.
A country exports wheat. It imposes a tariff on wheat imports. What happens?
- A tariff only affects goods that are imported
Show answer
Nothing: no one imports wheat, so the tariff has no effect. The tariff matters only if the country imports the good.
Why it matters
Arguments for restricting trade, and economists' replies (as Mankiw sets them out):
- Jobs. Trade destroys jobs in the import-competing industry, but it creates jobs in the export industries where the country has a comparative advantage.
- National security. Economists accept that protecting truly vital industries can be appropriate, but warn that the argument is easily overused by industries seeking protection.
- Infant industries. New industries say they need temporary protection to grow. Economists doubt that governments can pick which industries will succeed, and note that temporary protection tends to become permanent; firms that can be profitable in the long run should be willing to bear temporary losses, and many start-ups succeed without protection.
- Unfair competition. If another country subsidises its exporters, its taxpayers bear the cost, and the importing country's buyers gain more than its producers lose.
- A bargaining chip. Threatening restrictions might persuade others to drop theirs, but if the threat fails, the country must back down or carry out a threat that harms itself.
Multilateral agreements. Countries can cut barriers together. Mankiw's examples: NAFTA (1993) between the United States, Mexico and Canada, and GATT, which he credits with cutting average tariffs among members from about 40% after the Second World War to about 5%. The World Trade Organization (WTO), set up in 1995, enforces the rules. A multilateral approach can open markets abroad as well as at home, and can be politically easier, though failed negotiations could leave trade more restricted.
Worked example
The importing country from the last lesson: supply Q = 10P − 20, demand Q = 120 − 10P, world price 4. A tariff of 1 raises the price to 5.
| Free trade (price 4) | Tariff (price 5) | |
|---|---|---|
| Home supply | 20 | 30 |
| Home demand | 80 | 70 |
| Imports | 60 | 40 |
- Government revenue: 1 × 40 = 40.
- Producer gain: 1 × 20 + ½ × 1 × 10 = 25.
- Consumer loss: 1 × 70 + ½ × 1 × 10 = 75.
- Deadweight loss: 75 − 25 − 40 = 10: 5 from extra costly home production and 5 from purchases given up.
Text description
The same market as before, with a world price of 4. A tariff of 1 raises the home price to 5. Home supply rises from 20 to 30, home demand falls from 80 to 70, and imports fall from 60 to 40. The rectangle above the imports between 4 and 5 is the government's revenue: 40. The two small triangles, from 20 to 30 and from 70 to 80, are the deadweight losses, 5 each: costly extra home production and purchases given up.
Common mistake
Treating a quota as a cheaper way to protect an industry than a tariff. It has the same costs to buyers and the same deadweight loss; the only difference is that the extra money goes to licence holders instead of the government. Mankiw notes this makes quotas granted to foreign firms worse for the home country than an equivalent tariff.
Key terms
- tariff
- a tax on goods produced abroad and sold at home
- import quota
- a limit on the quantity of a good that can be imported
- deadweight loss
- the fall in total surplus caused by a distortion such as a tariff
- infant-industry argument
- the claim that new industries need temporary protection to grow
- multilateral approach
- cutting trade barriers through agreements among many countries
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| tariff | a tax on goods produced abroad and sold at home |
| import quota | a limit on the quantity of a good that can be imported |
| deadweight loss | the fall in total surplus caused by a distortion such as a tariff |
| infant-industry argument | the claim that new industries need temporary protection to grow |
| multilateral approach | cutting trade barriers through agreements among many countries |
Practice
Work it through
Using the worked example's market, the tariff is 2 instead, raising the price to 6.
- 10 × 6 − 20
- 120 − 10 × 6
- 60 − 40
- 2 × 20
Quick quiz
Tap an answer to check it.
What is the one difference Mankiw finds between a tariff and an import quota?
- Both raise the domestic price
Show answer
A tariff raises revenue for the government; a quota gives surplus to import-licence holders. Otherwise they have very similar effects.
How do economists usually answer the jobs argument against trade?
- It does cost jobs in import-competing industries
Show answer
Trade destroys some jobs but creates others in industries with a comparative advantage. Workers move towards the industries where the country has a comparative advantage.
Why are economists sceptical of the infant-industry argument?
- Some do; the doubt is about choosing them and ending the protection
Show answer
Governments find it hard to pick winners, and temporary protection tends to become permanent. Protection is hard to target and hard to remove.
In short
- A tariff raises the domestic price: buyers lose, producers and the government gain, and there is a deadweight loss.
- Quotas work like tariffs, except the extra money goes to licence holders.
- Arguments for restrictions (jobs, security, infant industries, unfair competition, bargaining) all have economists' replies.
- Multilateral agreements such as GATT and the WTO have cut tariffs widely.
Mastery check
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Check yourself
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In the worked example, what is the deadweight loss of the tariff of 1?
Show answer
10.
When does a tariff have no effect?
Show answer
When the country does not import the good.
According to Mankiw, how far did GATT cut average tariffs among its members?
Show answer
From about 40% after the Second World War to about 5%.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 9.
- On this site: Winners and losers from trade and Deadweight loss.
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