Tutorial on Partial Equilibrium Modeling: Import Quota by a Large Country Importer

1. Tutorial on Partial Equilibrium Modeling:Import Quota by a Large Country Importer The Microeconomics of International Trade ECN 230 Roberto J. Garcia School of Economics and Business, UMB

2. Economic effects of an import quota Import quota • A import quota is a trade policy instrument that aims to limit directly the traded volume between countries, e.g., setting the quantity imported, [QM]1, equal to a targeted quantity, Qq. • By limiting the quantity imported, a quota has implications for prices, which affects economic behavior and welfare. The economic effects are studied by analyzing the change in prices on: • Production, consumption and trade patterns, and • Producer and consumer welfare and the ability to earn quota rents by the governments or private agents. • A quota requires additional administrative (e.g., customs) measures to ensure that [QM]1  Qq.

3. Economic effects of an import quota Market analysis • Analyzing the production, consumption and trade effects: the perspective of the importing country Importer's domestic market World market [PD]1 [PW]1 [PD]1 [PW]1 [QS]1 [QD]1 [QM]1   

4. Economic effects of an import quota • Economic intuition and expectations • Regardless of the reason for a quota being implemented, the result is a reduction in the quantity imported, such that the quantity imported is  [QM]1 (ED1 is kinked becoming vertical at [QM]1 intersecting ES at [PW]1). • The world price decreases (PW) because a large buyer on the international market reduces demand, i.e., a negative TOT effect. • The internal price in the importer's market increases (PD) because there is greater scarcity of the good on the domestic market. • Producers and consumers react to the change in the domestic price, from PW to [PD]1. • Producers respond to price increases by increasing output, QS. • In partial equilibrium analysis, a price increase is expected to result in a decrease in consumption, QD. • Quota rents can be collected. Who collects the rents depends on how the quota is implemented (i.e., the licensing procedure to allocate the quota).

5. Economic effects of an import quota Welfare analysis • Analyzing economic costs and income transfers among producers, consumers, traders and the government: the importing country's perspective Importer's market - (a+b+c+d) + (a) [PD]1 [PW]1 + (c+e) - (b+d) + (e) Assumes the government earns the quota rents. [QS]1 [QD]1

6. Economic effects of an import quota • Economic interpretation of welfare areas • Area 'a' represents the value lost by consumers that is gained by producers, i.e., a tax on consumers; it is an income transfer from the consumer to the producer. • Area 'b' represents a part of the total value lost by the consumers that is not transferred to any other economic agent in the economy; it is a "dead-weight loss" (DWL) in production. • The DWL in production is the cost to society of producing more of the good in which the country has a comparative disadvantage. • The increased production reflects a misallocation of resources because resources are being used inefficiently. • Area 'c' represents a value lost by consumers making up part of the quota rents; if government sold import licenses at the market rate, then 'c' would be a cost the exporter pays which is past on to the consumer.

7. Economic effects of an import quota • Area 'd' represents part of the value lost by consumers that is not transferred to any other economic agent; it is a "dead-weight loss" (DWL) in consumption. • The DWL in consumption is the cost to society of consuming less of the imported good as a result of distorted prices. • The decreased expenditures reflects a misallocation of resources in consumption (ie, a non-optimal consumption mix). • Area 'e' represents the quota rents that can be collected along with area 'c'; the total quota rents are (c+e) which is equal to {[PD]1 – [PW]1} · [QM]1; however, area 'e' is an income transfer from the exporter to the government resulting from the TOT effect of the quota (i.e., the policy-induced reduction in demand by a large international buyer that lowered PW). • The net effect of the quota on the importer is uncertain because the negative DWLs can be offset by the income transfer from the exporting country. It will also depend on how the quota is administered and rent collection.

8. Economic effects of an import quota Market analysis • Analyzing the production, consumption and trade effects: the perspective of the exporting country World market Exporter's domestic market  

9. Economic effects of an import quota • Economic intuition and expectations • Application of an import quota results in a reduction in the quantity imported. Graphically, ED1 is kinked becoming vertical at [QM]1 if the quota is binding. It is assumed that the export-country's government does not take any policy action to counter the quota. • The world price decreases (PW) because a large buyer on the international market reduces demand. • The internal price in the exporter's market is the new world price because no policy action has been taken. • Producers and consumers react to the change in the domestic price, from PW to [PW]1. • Producers respond to price decreases by decreasing output, QS. • In partial equilibrium analysis, a price decrease is expected to result in an increase in consumption, QD. • Because the export-country government has not taken action, there are no budgetary outlays on, taxes from, or rents collected from licensing the exported good.

10. Economic effects of an import quota Welfare analysis • Analyzing economic costs and income transfers among producers, consumers, traders and the government: the exporting country's perspective Exporter's market + (1) - (1+2+3+4) 0 - (2+3+4) Assumes the import- country's government collects all quota rents

11. Economic effects of an import quota • Economic interpretation of welfare areas • Area '1' represents the value gained by consumers from the lower price; it is an income transfer from producers to consumers. • Area '2' represents a part of the total value lost by the producer that is not transferred to any other economic agent in the economy; it is a "dead-weight loss" (DWL) in consumption. • The DWL in consumption is the cost to society of consuming more the exportable good and becoming less reliant on trade. • The increased consumption reflects a misallocation of resources because the world price has been distorted. • Area '3' represents the value lost by producers that is gained by the importing government; it is an income transfer from the producer/exporter to the importer's government in the form of a tax as a result of the TOT effect.

12. Economic effects of an import quota • Area '4' represents a part of the value lost by the producers that is not transferred to any other economic agent in the economy; it is the "dead-weight loss" (DWL) in production. • The DWL in production in the exporting country is the cost to society of producing too little of the exportable good, the good in which the country has a comparative advantage. • The decreased production reflects a misallocation of resources away from the export sector, stifling the specialization process. • The net effect of the import quota, administered by the government of the importing country, on the exporting country is negative, resulting in the DWLs and an income transfer to the importing country. An import quota that is administered differently to the scenario in this example can result in a much different net effect because the quota rents can accrue to the exporter, the exporting country's government or shared among many different agents in both countries.

13. Economic effects of an import quota Net world welfare effects • Internal domestic transfers, DWLs and international transfers - (b+d) + (e) Importer's market Exporter's market - (2+4) - (3) (e) = (3) - (b+d) - (2+4)

14. Economic effects of an import quota Concluding comments • The import quota by a large country results in a TOT effect that affects importers and exporters differently: • 1. A decrease in the world price benefits the importing country(ies) at the expense of the exporting country(ies) • 2. The higher domestic price in the importing country is a price support to domestic producers which is paid by domestic consumers. • 3. The lower world price in the exporting country is a tax on its producer/exporters, particularly if they do not earn the quota rents. Consumers in the exporting country benefit from a lower price. • 4. Assuming all rents go to the importing country's government, part of the rents collected is an international income transfer from the producers/exporters, i.e, it is a tax by the importer on the exporter, and the other part is a transfer from domestic consumers. • 5. The net effect of the quota on the world economy is an international income transfer and a series of DWLs in production and consumption in both countries because prices have been distorted. This is the case regardless of which economic agent collects the quota rents and how the quota is administered.