Page 187 - The Principle of Economics

It is not surprising that a tariff causes a deadweight loss, because a tariff is a type of tax. Like any tax on the sale of a good, it distorts incentives and pushes the allocation of scarce resources away from the optimum. In this case, we can identify two effects. First, the tariff on steel raises the price of steel that domestic producers can charge above the world price and, as a result, encourages them to increase pro- duction of steel (from Q1S to Q2S). Second, the tariff raises the price that domestic steel buyers have to pay and, therefore, encourages them to reduce consumption of steel (from QD1 to QD2 ). Area D represents the deadweight loss from the overpro- duction of steel, and area F represents the deadweight loss from the undercon- sumption. The total deadweight loss of the tariff is the sum of these two triangles.
THE EFFECTS OF AN IMPORT QUOTA
The Isolandian economists next consider the effects of an import quota—a limit on the quantity of imports. In particular, imagine that the Isolandian government dis- tributes a limited number of import licenses. Each license gives the license holder the right to import 1 ton of steel into Isoland from abroad. The Isolandian econo- mists want to compare welfare under a policy of free trade and welfare with the addition of this import quota.
Figure 9-7 shows how an import quota affects the Isolandian market for steel. Because the import quota prevents Isolandians from buying as much steel as they want from abroad, the supply of steel is no longer perfectly elastic at the world price. Instead, as long as the price of steel in Isoland is above the world price, the license holders import as much as they are permitted, and the total supply of steel in Isoland equals the domestic supply plus the quota amount. That is, the supply curve above the world price is shifted to the right by exactly the amount of the quota. (The supply curve below the world price does not shift because, in this case, importing is not profitable for the license holders.)
The price of steel in Isoland adjusts to balance supply (domestic plus im-
ported) and demand. As the figure shows, the quota causes the price of steel to rise
import quota
a limit on the quantity of a good that can be produced abroad and sold domestically
above the world price. The domestic quantity demanded falls from QD1 to QD2 , and SS
the domestic quantity supplied rises from Q1 to Q2. Not surprisingly, the import quota reduces steel imports.
Now consider the gains and losses from the quota. Because the quota raises the domestic price above the world price, domestic sellers are better off, and do- mestic buyers are worse off. In addition, the license holders are better off because they make a profit from buying at the world price and selling at the higher domestic price. To measure these gains and losses, we look at the changes in consumer surplus, producer surplus, and license-holder surplus, as shown in Table 9-4.
Before the government imposes the quota, the domestic price equals the world price. Consumer surplus, the area between the demand curve and the world price, is area A 􏰀 B 􏰀 C 􏰀 D 􏰀 E' 􏰀 E''􏰀 F. Producer surplus, the area between the sup- ply curve and the world price, is area G. The surplus of license holders equals zero because there are no licenses. Total surplus, the sum of consumer, producer, and license-holder surplus, is area A 􏰀 B 􏰀 C 􏰀 D 􏰀 E' 􏰀 E'' 􏰀 F 􏰀 G.
After the government imposes the import quota and issues the licenses, the domestic price exceeds the world price. Domestic consumers get surplus equal to area A 􏰀 B, and domestic producers get surplus equal to area C 􏰀 G. The license holders make a profit on each unit imported equal to the difference between the
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 189