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IFT Notes for Level I CFA® Program

LM07 International Trade and Capital Flows

Part 3


6. Trade and Capital Flows: Restrictions & Agreements – Tariffs, Quotas and Export Subsidies

6.1 Tariffs

Tariffs are taxes imposed by a government on imported goods. Tariffs are common in countries where the government finds it difficult to collect taxes from its citizens.

Why governments levy tariffs:

  • To protect domestic industries.
  • To reduce trade deficit. Tariffs reduce the demand for imports by increasing their price above the free trade price.

“Small” country: A country is a price taker in the world market for a product, and is too small to affect the world market price. Small country does not mean it is small in size, population or GDP. For example, India is a large country, but it is a price taker for luxury bikes like Ducati, Harley Davidson, and Triumph.

“Large” country: A country is a large importer of the product and can influence the world market price. For example, the United States is a large country for the automobile market. If it were to impose tariffs on imported cars, then exporters would reduce the price of the cars to retain market share.

Generally, tariffs result in loss in global welfare. The exhibit below illustrates the wealth effects of tariffs and quota.

Welfare effects of Tariff and Import Quota

econ r19 3.1 1

Key points of the exhibit are summarized below:

  • Under free trade: Q1 is domestic supply, Q4 is domestic consumption. Import demand = demand – supply = the distance between Q1 and Q4. Assume the country is Portugal; a small country from a trade perspective, and it imports cars. It is a price taker and the price per car (P*) is 100.
  • After tariff is imposed:Q2 is domestic supply, Q3 is domestic consumption. Import demand = the distance between Q2 and Q3. Domestic producers supply more and consumers demand less. The price is represented by Pt. Assume Portugal imposes a 50% tariff, so the price of the car is now 150.

Interpretation of what happens after the tariff:

  • Tariff results in a deadweight loss, known as welfare loss here, denoted by B + D.
  • Producer surplus increases to A because of a higher price for their output.
  • Government revenue increases because of the tariff collected, as denoted by C.
  • Consumer surplus decreases because of the increase in price.

The welfare effects are tabulated below:

Importing country
Consumer surplus – (A + B + C + D)
Producer surplus + A
Tariff revenue or quota rents + C
National welfare – B – D

This example was for a small country. Now, let us look at it from a large country’s perspective. The terms of trade change. Assume the large country is the United States that imports cars from Japan. If the U.S. imposes a tariff, then Japan will reduce the price of cars. Terms of trade for the U.S. will improve as the price of imports has gone down.

The outcome is:

  • For the importing country (U.S.): producers gain, but consumers lose.
  • Creates tariff revenue for the government.
  • For the exporting country (Japan): producers lose but consumers gain.

Example 5 from the curriculum will provide better understanding of the concept.

6.2 Quotas

Quota is a restriction on the absolute amount (quantity) of imports allowed over some period, typically a year. An import license specifies the maximum quantity that can be imported during a given period; it is used to implement a quota.

  • Quota rents: The extra profit earned by foreign producers. Exporters earn greater profits with quotas because they often raise the price of their goods.
  • To understand the difference between tariffs and quotas, let us consider the same example.

Welfare effects of Tariff and Import Quota

econ r19 3.2 1


  • At first glance, tariff and quota look similar. But, there is a subtle difference between the two in government revenue and loss of welfare. With tariffs, it was clear that region C was the revenue earned by the government. But, in the case of quota, these are profits earned by the exporters as they raise the prices of their goods. If there was no quota, the prices of these goods would not have increased.
  • With tariffs, the loss in welfare was equal to the deadweight loss of B+D. But, with quotas, it is equal to B+C+D. The amount lost in C can be eliminated if the government sells the import licenses to the exporters for a fee, and this amount must be equal to C.

Voluntary export restraint: Export quota administered by the exporting country; exporting country agrees to limit exports of a particular good usually at the request of the importing country to avoid tariffs or quotas. A VER allows importing countries to protect domestic industries from a surge of imports. The difference between an import quota and a VER is that the former is imposed by the importing country, while the latter is imposed by the exporter. One example of a VER is between Japan and U.S. from 1981 to 1994. The U.S. recognized the rising popularity of Japan’s cars in the early 1980s and wanted to protect its domestic automobile industry. In 1981, the Japanese government responded by entering into a VER agreement with the U.S. limiting the number of cars exported to the United States to 1.68 million a year.

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