Tariffs and Quotas

Protectionist trade policies are defined as trade policies designed to limit imports; that is, they are government policies intended to “protect” an economy from foreign competition. Protectionist trade policies are part of the Mercantilist plan to encourage exports and limit imports. Protectionist trade policies are the opposite of free trade, which is the government policy of allowing imports and exports to move freely among countries.

Our goal this week is to identify the most common forms of protectionist trade policies and to examine whether they achieve their intended effects.

We begin by discussing the two most familiar protectionist trade policies: tariffs and import quotas.

Tariffs

A tariff is defined as a tax on imports. When an imported products arrives in the U.S., the producer must pay a tax equal to some percentage of the value of the product (that percentage varies from product to product).

A tariff is thus an added cost to the producer who must pay the tax. It raises the cost of importing products from other countries. Because it makes imports more costly to produce and sell, a tariff reduces the supply of imports into a country. That reduces the overall supply of that product in the country.

We know that when supply is cut, the price will rise and the equilibrium quantity will also fall.

Import Quotas

According to VH-1’s “Pop-Up Video” clip of the 1980s song “Take On Me” by the band a-ha, two-thirds of all Americans don’t know what an import quotas is. (How’s that for an obscure reference! Apparently this tidbit as included with this particular song because the band a-ha is from Norway.) An import quota is defined as a numerical limit on the amount of imports allowed into a country. The U.S. imposes import quotas on a variety of agricultural products, most notably cheese and sugar. Until recently, there was an import quota on textiles.

What are the effects of an import quota? It is a direct reduction in supply, and therefore leads to an increase in price and a fall in equilibrium quantity – just like a tariff.

The effects of tariffs and quotas

Since tariffs and quotas both reduce the supply of imports, and thus raise price and reduce quantity, we can analyze the further effects of tariffs and quotas together. That is, we can examine the effects of a tariff and know that the effects of a quota will be exactly the same.

We’ll organize our discussion of the effects of tariffs and quotas by asking who wins and who loses as a result of a tariff. And to be specific, let’s consider the tariff that the U.S. places on imported steel.

Who gains from a tariff?

Domestic producers of steel will face lower competition because of the reduced supply of imported steel. What do producers do when there is less competition? They raise price. Note that a tariff thus results in a higher price not only of imported steel but also of domestic steel (i.e. steel produced in the U.S.)

And since there is less competition, domestic producers will increase their production of steel. To do so, they’ll hire more workers.

So the winners from a tariff on imported steel are U.S. steel companies and their workers.

Who loses from a tariff?

The obvious answer is, U.S. consumers. They have to pay a higher price for steel. Of course, most consumers don’t buy hunks of steel – but they do buy things made from steel. Producers of cars and appliances and caskets and building materials all pay higher prices for steel, and they pass some of those higher prices along to consumers in the form of higher prices for cars, appliances, caskets, etc.

But U.S. consumers aren’t the only losers. U.S. export producers are also hurt. The circular flow argument applies here. A tariff means that we buy fewer imports of steel from South Korea and China and Germany. As a result, South Koreans and Chinese and Germans have less income with which to buy our products. So U.S. producers who make things for export to other countries will sell less, and they will thus lay off workers.

So there will be fewer imports coming and fewer exports going out. That means there is less demand for transportation workers -- we don’t need as many people working on the docks loading and unloading containers, we don’t need as many ship crew members, we don’t need as many airplane pilots.

Overall, then, some people are made better off by a steel tariff and other people are made worse off. Does that mean then that tariffs and quotas have no overall impact on the economy?

Protectionist Trade Policies and GDP

In fact, tariffs and quotas have one other important effect. They reduce GDP.

To see how, think about this: why do we import steel from South Korea in the first place? Because they can produce it more cheaply than we can. Remember that resources involve an opportunity cost: We can use our resources better doing something else. It’s cheaper for us (cheaper in opportunity cost terms) to import steel and then to use the resources that we would have used to make steel to produce something else that we’re especially good at.

Or think of it this way: how much coffee do we grow in the U.S.? Essentially, none. Why is that? Because we don’t have the climate that is best suited for growing coffee. We could grow our own coffee, but it would require construction of enormous greenhouses with the right climate controls. We could do that, but it would be very costly to do so. We do better by using our resources to produce banking and legal services and getting our coffee from countries that have the resources that are right for growing coffee.

Thus, when we part a tariff on imports, we are denying ourselves the cheapest source of those products. We are forcing ourselves to make more steel ourselves, even though our resources could be spent better elsewhere. That means that we are not putting our resources to their best uses. As a result, our total production, out total income, our GDP, is less than it would otherwise be.