Import Quota and Tariff Under Imperfect Competition, University of Aberdeen

Introduction to Import Quota and Tariff

Dr Eva Pocher
eva.pocher@abdn.ac.uk
EC3024
International Economics
Lecture 9

1495
UNIVERSITY OF
ABERDEEN

Aim of Today's Lecture 9

• To study the effects of a tariff under the assumption of a Home
  monopoly
• To study the effects of a quota under the assumption of a Home
  monopoly.
• To study the effects of a tariff under the assumption of a Foreign
  monopoly

Dumping

No-Trade Equilibrium (Home Monopoly)

Tariffs and Quotas with Home Monopoly Analysis

• Analysis of tariffs and quotas in the presence of a Home monopolist:

> A single firm selling a homogeneous good.
. Important in this analysis: the concept of market power:
> The extent to which a firm in the market can set its price.
· Tariffs and quotas affect the Home monopolist's market power
in different ways

Tariffs and Quotas with Home Monopoly: No-Trade Equilibrium

. The extra revenue from selling one more unit of the good is called
marginal revenue, and denoted MR
. The extra cost of producing one more unit of the good is called
marginal cost, and denoted MC.
· To maximize profits, the monopolist produces at the point
where MR = MC
· Under perfect competition, selling price = production cost
→
the industry supply curve is given by MC

Tariffs and Quotas with Home Monopoly: Price and Quantity

Price
Monopoly
equilibrium
A
Marginal
cost, MC
B
pc
Perfect competition
equilibrium
Marginal
revenue, MR
Home
demand, D
Q™
M
Q'
Quantity

In monopoly, equilibrium
occurs at point A, where
MR = MC
Under perfect competition,
equilibrium occurs at point
B, where D = MC (i.e.
demand equals supply).

Tariffs and Quotas with Home Monopoly: Output Restriction

Price
Monopoly
equilibrium
A
Marginal
cost, MC
p™
B
pc
Perfect competition
equilibrium
Marginal
revenue, MR
Home
demand, D
Q"
Quantity

In absence of trade, the
monopolist can restrict
Output Q to increase Price
P
Under free trade, however,
the Home monopolist no
longer has control over price
P

Free Trade Equilibrium (Home Monopoly)

Tariffs and Quotas with Home Monopoly: Free-Trade Equilibrium

Price
No-trade,
monopoly
equilibrium
Free-trade
equilibrium
PM
A
MC
pw
X* = MR*
B
: MR
D
.
.
.
Q™ S.
M
D1
Quantity
L
Imports, M1

Home is a small country, i.e. it
can import as much as it
wants at world price PW->
Foreign export supply X* is
perfectly elastic.
The Home firm can sell as much
as it desires at price PW ->
X* is the Home firm's de facto
demand curve.

Tariffs and Quotas with Home Monopoly: Marginal Revenue

Price
No-trade,
monopoly
equilibrium
Free-trade
equilibrium
A
MC
p™
PW
X* = MR*
B
: MR
D
·
.
QM S.
1
DA
Quantity
Imports, M1

Since this demand curve is flat,
marginal revenue is equal to
demand, i.e. MR* = X*
The monopolist maximizes
profit by setting MR* = MC,
i.e. at point B
Since equally supply S1 is
exceeded by consumer demand
D1, consumers import
quantity M1.

Comparison with Perfect Competition (Free Trade)

Tariffs and Quotas with Perfect Competition: Free Trade

. Under free trade for a small country, a Home monopolist
produces the same quantity and charges the same price asa
perfectly competitive industry. (i.e. supply MC equals firm
demand X*)
. Hence, free trade eliminates all of the monopolist's control
over price (i.e. all its market power).
. There are gains from trade.

Home Tariff

Effect of a Home Tariff: Price Increase

Price
MC
Equilibrium
with tariff
C
pw + t
X* + t = MR*
a
b
C
id
**
Free-trade
equilibrium
D
S1
S2 D2 D1
Quantity
Imports with
tariff, M2
J
Imports (free trade), M1

A tariff t increases the Home
price from PW to PW + t
At this price, Foreign will ex-
port any amount to
Home:
>New Foreign export supply
curve is X* + t
The Home firm can sell any
amount at price PW + t:
- New Home firm demand
curve is X* + t
PW
.B

Effect of a Home Tariff: Equilibrium Shift

Price
MC
Equilibrium
with tariff
C
pw + t
X + t = MR
*
a
b
C
id
PW
. B
Free-trade
equilibrium
D
S1
S2
D2 D1
Quantity
Imports with
tariff, M2
Imports (free trade), M,
By the same reasoning as
above, this means Home firm
marginal revenue is:
MR* = X* + t.
The equilibrium shifts from
point B to point C.
As before, the tariff increases
supply (S1 to S2), decreases
demand (D1 to D2), and thus
decreases
imports (M1 to
M2)

Effect of a Home Tariff: Welfare Effects

Price
MC
Equilibrium
with tariff
C
pw + t
X* + t = MR*
a
b
C
id
**
Free-trade
equilibrium
D
S1
S2
D2 D1
Quantity
Imports with
tariff, M2
Imports (free trade), M1

The welfare effects of the tariff are
summarized as follows:
Fall in CS:
-(a+ b+ c+ d)
Rise in PS:
+ a
Rise in GR:
+ C
Net effect:
-(b+ d)
PW
.B
The deadweight loss continues to
be the sum of production loss band
consumption loss d.

Comparison with Perfect Competition (Tariff)

Effect of Home Tariff: Monopolist Behavior

Comparison with perfect competition:
Because the monopolist has limited control over its price, it
behaves in the same way as a competitive industry when faced
with a tariff.
Hence, the welfare effect of a tariff is exactly as under perfect
competition.

Effect of Home Quota

Effect of a Home Quota: Sheltered Market

. In contrast with a tariff, a quota creates a "sheltered market" for
the Home firm
. It allows the monopolist to keep its market power, and thus to
maintain higher (non-competitive) prices
. This is another reason why the WTO has encouraged countries to
replace quotas with tariffs

Effect of a Home Quota: Price and Production

Price
Quota, M2
MC
P2
3
C
pw + t
B
pw
E
Equilibrium
with quota
D -'M:
D
MR :
.
:
.
S3 51 S2
D
D2 D1
Quantity
Imports with tariff or quota are the same
1
Imports (free trade), M1

Under free trade, the Home
monopolist produces at point
B and charges the world price
of pW.
.
With a tariff of t, the
monopolist produces at point
C and
charges the price of
pW+t. Imports under the tariff
are M2 = D2 -S2.

Effect of a Home Quota: Demand Curve Shift

Price
Quota, M2
MC
P2
C
pw + t
B
pw
:
E
Equilibrium
with quota
D - M;
.
D
MR :
·
S3 S1 S2
D3
D2 D1
Quantity
Imports with tariff or quota are the same
1
Imports (free trade), M1

Under an "equivalent" quota of
M2, the demand curve shifts
M2 to the left; - > the Home
firm's demand curve becomes
D -M2.
After M2 units are imported,
the monopolist is the only firm
able to sell at Home, and can
thus choose any price along the
demand curve D -M2.

Effect of a Home Quota: Higher Home Price

Price
Quota, M2
MC
P2
3
C
pw + t
B
pw
E
Equilibrium
with quota
D - M:
D
MR :
:
S3 51
S2
D
D2 D1
Quantity
Imports with tariff or quota are the same
Imports (free trade), M1

The marginal revenue curve cor-
responding to D - M2 is MR
> the Home firm produces at
point E, where MR = MC.
The corresponding price is P3
> pW + t, i.e. the quota
leads to a higher Home price
than the tariff.

Effect of a Home Quota: Home Loss

Home Loss due to the Quota:
With an import quota, the Home firm is able to charge a higher
price than it could with a tariff because it enjoys a "sheltered"
market.
Bigger loss in CS, and additional DWL due to the exercise of
monopoly power
tariff DWL < quota DWL
(even ignoring the possibility of rent seeking or loss of quota rents
Under Voluntary Export Restrains)

Empirics

Empirics: Japanese Automobiles Imports

. A well-known case of a "voluntary" export restraint (VER) for the
United States occurred during the 1980s, when the U.S. limited the
imports of cars from Japan.
. A recession led to less spending on durable goods (such as
automobiles
→
unemployment in the auto industry rose sharply.
. In 1980, the United Automobile Workers and Ford Motor Company
applied to the International Trade Centre (ITC) of the WTO for
protection under Section 201 of U.S. trade laws.

Empirics: Japanese Government Response

. The ITC advised against protecting the auto industry
· In response, several congressmen with auto plants in their states
pursued other means. A bill was introduced in the U.S. Senate to
restrict imports.
. Aware of its potential consequences, the Japanese government an-
nounced it would "voluntarily" limit Japan's export of
automobiles to the U.S.
· By 1988, Japanese exports were below the VER because Japanese
firms were producing their cars in the U.S.

Empirics: Japanese Car Imports Price Increase

. Between 1980 and 1985, prices of Japanese car imports rose from
$5,150 to $8,050 due to the VER; of this $2,900 increase
- $1,100 was quota rents
total quota rents: $2.2 billion
- $1,650 was due to quality upgrades
- $150 the normal increase under free trade
· Japanese firms' stock prices went up as a result

Empirics: Prices of Japanese Car Imports Figure 2

Em
pirics
$9,000
Price with quota rents
(and quality upgrading)
8,000
7,000
6,000
Price with quality
upgrading
5,000
Free-trade price
4,000
3,000
1979
1980
1981
1982
1983
1984
1985
Figure 2: Prices of Japanese Car Imports

Empirics: U.S. Cars Price Increase

. Average price of U.S. cars rose rapidly due to the VER (43% between
1979 and 1981).
. U.S. producers exercised market power in the "sheltered" part of
their market.
. Only a small part of the price increase is accounted for by quality
improvement.
. Both U.S. and Japanese firms were better off under the VER
→
The policy was very costly to U.S. consumers.
. This loophole in Section XI of the GATT was closed in 1995

Empirics: Prices of American Small Cars Figure 3

$8,000
Price with quality upgrading
7,000
6,000
Price without quality upgrading
5,000
4,000
3,000
1979
1980
1981
1982
1983
1984
Figure 3: Prices of American Small Cars.

Tariffs with Foreign Monopoly

Tariff with Foreign Monopoly: Assumptions

1. Home consumers import goods from a Foreign monopolist.
2. There is no competing Home firm >all Home demand D is
   catered to by the Foreign firm.
   > This is not very realistic, but it simplifies the analysis.)
3. Goods sold in the Home market are produced at marginal cost MC*

Tariff with a Foreign Monopoly: Free Trade

Tariff with a Foreign Monopoly:
Price
Increase in P
is less than t,
the increase
in MC
C
P2
P1
e
P3=P2-t
B
MC* + t
Increase in
MC due to
tariff, t
t
MC*
A
D
MR
Under free trade the Foreign
monopolist charges P1 and
exports
X1, where MR
= MC*
A tariff t raises the Foreign
monopolist's marginal cost
to MC* + t
Exports fall to X2 and the
Home price rises to P2
X2 X1
Foreign exports

Tariff with a Foreign Monopoly: Consumer Surplus

Tariff with a Foreign Monopoly:
Price
Increase in P
is less than t,
the increase
in MC
C
P2
2
P1
e
P3 = P2 - t
B
MC + t
Increase in
MC due to
tariff, t
t
MC*
A
D
MR
X2 X1
Foreign exports

The decrease in consumer
surplus is c + d; however, c
is collected as a portion of
tax revenues.
The net-of-tariff price
that the Foreign exporter
receives falls to P3 = P2 - t
This drop in the price is a
ToT gain for Home; it is
represented by the area e.