Protectionist policies in the form of tariffs and quotas are coming from a Trump Administration. It seems appropriate then that we examine tariffs and quotas from a macroeconomics perspective.
The two most common ways of restricting trade are with tariffs and quotas. From a political point of view and to prevent a trade war, a Trump Administration should consider the use of quotas over tariffs in some cases.
This figure illustrates the domestic market for food in Europe.
The equilibrium between supply and demand occurs at point A at a price of $8, and quantity of two hundred. Now, suppose that food is available in an unlimited amount from the rest of the world, at a price of $4 per unit and Europe doesn’t like this because it hurts their farmers.
The world supply curve is represented by the red horizontal line. In the absence of any transportation costs, the food price in Europe must be equal to the world price of $4. At the $4 price, you can see that European domestic production is measured by the line segment B, C and will be one hundred units, considerably less than before free trade.
American imports are measured by the line segment C, D and are equal to two hundred units, and revenues from the sale of these imports are equal to the shaded area C, D, E, F.
Now let’s say that European trade ministers impose a tariff of $2 per unit on food imports, where a tariff is a tax levied on imports. What happens now to domestic production and imports?
Clearly, domestic producers win because their production not only rises by fifty units, but their profits rise by the shaded area B, C, H, G.
European food consumers lose, not only because the price of food rises from $4 to $6, but also because they consume fifty fewer units of food. In fact, the total loss to consumers is measured by the area B, D, I, G.
The other big loser is the American food industry, which now exports one hundred fewer units and loses revenues equal to the shaded areas C, J, L, E and K, D, M, F.
The winner is the European governments that imposed the tariff. They collect tariff revenues, equal to the area H, I, J, K.
The Politics of Tariffs
From a political perspective, a relatively small handful of people in one domestic industry, farming, have gained a considerable profit at the expense of a much larger, but politically less powerful group, food consumers.
This protectionist tariff has also considerably harmed food producers in America, and this group is unlikely to remain silent on the tariff.
Why Quotas Trump Tariffs Politically
One likely result is that pressure will build politically in America to retaliate against European food tariffs with protectionist tariffs of its own, perhaps on European clothing imports. There is a way for Europe to avert this trade war and it’s with a quota which is an exact quantity limit on imports.
An equivalent quota, in this case, would be a one hundred unit limit on American food since that is the level of imports after the $2 per unit tariff.
Under a tariff, the shaded area H, I, K, J goes to the European governments in the form of tariff revenues. However, under a quota foreign exporters (American food producers) will be able to capture these revenues which will mostly offset their losses from selling fewer exports. The result in America will be far less political pressure from food producers for retaliatory tariffs.
Whenever a government interferes in a free market, there is usually deadweight loss. There is deadweight loss associated with the imposition of a tariff or quota. In fact, the loss is the same regardless of whether a tariff or quota is used.
The shaded area C, H, J, represents the loss in producer surplus. In this case, too many European resources are being diverted into the inefficient production of food, at the expense of production in other sectors. At the same time the shaded area K, I, D represents the loss in consumer surplus and the loss in consumer satisfaction, from consuming fewer units of food. Together the two shaded triangles measure the total deadweight loss from tariffs or quotas.
Source: This lesson was made possible by the University of California Irvine and my favorite professor Dr. Peter Navarroopens in a new window, now economic advisor to the Trump Administration.