Instruments of


UNIT 6 INSTRUMENTS OF PROTECTIONISM Protectionism

Structure
6.0 Objectives
6.1 Introduction
6.2 Tariff Barriers
6.2.1 Classification of Tariffs
6.2.2 Effective rate of protection
6.2.3 Economic Impact of Import Tariff in partial equilibrium analysis
6.2.4 General Equilibrium Analysis: Impact of Tariff on Volume of Trade
and Terms of Trade (TOT)
6.3 Export subsidy
6.4 Non Tariff barriers
6.4.1 Import Quota
6.4.2 Voluntary Export Restraint
6.4.3 Other Non-tariff Barriers
6.5 Let us Sum Up
6.6 Key Words
6.7 Some Useful Books
6.8 Answers/Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After studying this Unit, you should be able to:
 explain various tariff and non-tariff barriers;
 identify the economic impact of Import tariff in partial equilibrium analysis;
 explain the effect of a tariff on production and consumption;
 describe export subsidy and its impact on the economy;
 identify the welfare effects of an export subsidy on producer and consumer
groups and the government in the exporting country;
 calculate the national and world welfare effects of an export subsidy; and
 explain various quantitative restrictions in international trade.


Adapted from Unit 4 of the course MEC 004 written by Dr. Ananya Ghosh Dastidar
111
Free Trade versus
Protectionism 6.1 INTRODUCTION
In unit 5, we discussed free trade and protectionism. Free trade allows imports
and exports without tariffs or other trade barriers. At the same time,
protectionism imply restrictions imposed on international trade to protect
domestic industries. The idea behind protectionist policies is to benefit the
domestic producers. We also discussed about benefits and costs associated with
protectionism. In present unit, we will discuss about instruments of
protectionism. The tools of trade protection that countries typically use to restrict
imports can be broadly classified into price-related measures such as tariffs and
non-price measures or non-tariff barriers (NTBs).
A tariff is a tax imposed on imports. Tariffs can be imposed on imports of both
final and intermediate goods. Tariff on final and intermediate goods is considered
while estimating the effective rate of protection provided to the domestic
industries.
In this unit, we will discuss the concept of 'effective rate of protection', which
measures the extent of actual protection provided to domestic industry based on
tariffs imposed on final and intermediate goods. Non-tariff barriers (NTBs) are
applied to quantities and other attributes of traded goods and services.
We discuss each of these instruments of trade protection in turn.
The tools or instruments of trade protection that countries use to restrict imports
can be classified into two categories: tariffs, price-related measures, and non-
tariff barriers (NTBs), which are non-price measures.
Tariffs: Tariffs are taxes that are imposed on imported goods. They increase the
price of imported goods, making them less competitive in the domestic market,
which can provide some degree of protection to domestic producers. There are
different types of tariffs, such as specific tariffs (based on the quantity or weight
of the imported goods) and ad valorem tariffs (based on the value of the imported
goods). Tariffs can be imposed at different stages of production or trade, such as
at the border or on intermediate goods, which affects the overall level of
protection provided to domestic producers.
Non-tariff barriers (NTBs): NTBs are measures that countries use to restrict
imports without necessarily imposing a tax or a duty on imported goods. These
can include measures such as quotas, which limit the quantity of a particular
product that can be imported into a country, and voluntary export restraints
(VERs), which are agreements between exporting and importing countries that
limit the quantity of exports of a particular product. NTBs can also include
technical barriers to trade (TBTs), which are regulations or standards that are
used to restrict imports of certain products, and anti-dumping measures, which
are imposed when a foreign producer is found to be selling goods in the domestic
market at a lower price than in the exporting country.
112
In addition to these measures, subsidies are another tool that countries use to Instruments of
Protectionism
protect domestic industries. Subsidies are payments or other types of support
provided by governments to domestic producers. They can be used to make
domestic products more competitive by reducing their production costs, which
can help protect domestic industries from foreign competition.
It is important to note that while these measures can protect domestic industries,
they can also negatively affect consumers by increasing the cost of imported
goods and other industries that rely on imports of intermediate goods. Therefore,
countries need to carefully consider the trade-offs involved in using protectionist
measures and weigh the benefits of protecting domestic industries against the
costs to consumers and other industries.

6.2 TARIFF BARRIERS

As we have discussed in the previous unit, Tariff is a duty or tax imposed by the
government of a country upon the traded commodity as it crosses the national
boundaries. The levying of import tariffs brings relative changes in the prices of
factors and products. Thus, the tariff brings an important change in the structure
of international trade. Though many, various trade barriers advocate free trade,
do exist in international trade. An import tariff is one of them. We have discussed
various arguments in favour of trade protectionism in Unit 5. Majorly, countries
impose trade barriers to protect their domestic industries or sectors from foreign
competition, to conserve the foreign exchange reserves of the country and also to
avoid dumping
In this section, we will discuss different categories of tariffs along with the effect
of a tariff on the economy.

6.2.1 Classification of Tariffs

Tariffs are of several types, and these can be classified into different groups or
sub-groups as below:
1) Classification based on Criterion for tariff imposition:
Based on the criterion for tariff imposition
These can be of the following types:
a) Specific tariff,
b) Ad Valorem tariff,
c) Compound tariff and
a) Specific Tariff:
A specific tariff is the fixed sum levied on each unit of the commodity
imported or exported. Sometimes, weight or any other measurement of a
commodity is charged instead of the physical unit. Such duties can be 113
Free Trade versus
Protectionism levied on goods like wheat, rice, fertilizers, cement, sugar, cloth etc.
Specific duties are quite easy to administer, as they do not involve the
evaluation of the goods. Imposition of specific duties enables the
government to keep out of the complexities of prices.
However, specific duties cannot be levied on high-valued goods such as
diamonds, jewellery, watches, T.V. sets, motor cars, works of art like
paintings etc. These articles can be taxed either based on weight, the
surface area covered or the number of articles.
b) Ad Valorem Tariff:
‘Ad Valorem’ is the Latin word that means ‘on the value.’
When the duty is levied as a fixed percentage of the value of the traded
commodity, it is called an Ad Valorem tariff. Such duties are levied on the
products the value of which is disproportionately higher compared to their
physical characteristics such as weight or measurement. These duties are
more equitable as the costly goods, generally consumed by the rich, bear a
greater burden of duty, while the cheaper goods bought by the poor, bear a
lesser burden of tariff.
c) Compound Tariff:
The compound tariff is a combination of specific and ad valorem tariffs.
The compound tariff includes specific duty on each unit of the
commodity along with a percentage of ad valorem duty. Compound
tariffs bring a greater elasticity to revenues. They also ensure more
effective protection for domestic industries.
2) Classification based on the Purpose which a Tariff serves:
Based on the purpose that tariff serves, Tariffs can be of two types:
a) Revenue Tariff and
b) Protective Tariff.
a) Revenue Tariff:
Sometimes the intention of the government behind imposing tariffs is
revenue generation. Especially in developing countries, the government
sometimes rely on tariffs as a source of revenue.
However, many times imposing tariffs also doesn't generate revenue.
Tariff imposition may also lead to a shift of consumer demand from
imported goods to domestic products, thus reducing the tariff collection.
Usually, the rate of revenue tariff is kept low so that the revenue generated
from the tariff is not curtailed because of reduced imports.

114
 b) Protective Tariff: Instruments of
Protectionism
When the purpose behind the imposition of a tariff is the protection of
domestic industries from foreign competition, the tariff is called a
protective tariff. As against revenue tariff, the rate of protective tariff is
kept higher to reduce the imports. When the tariff rate is higher the
protective effect of the tariff is also greater. A perfect protective tariff will
prohibit imports. However, a case against protective tariffs is that because
of zero competition from foreign producers, domestic producers will
become inefficient and they might not be able to face competition even in
long run.
3) Classification based on Discrimination:
Tariff systems can be classified into three categories based on their
application in different countries.
a) Single-Column tariff
b) Double-Column tariff
c) Triple-Column tariff
a) Single-Column Tariff:
The Single-Column Tariff also known as the uni-linear tariff system
provides uniform tariff rates to all commodities irrespective of the
country of origin. It is a simple tariff system and is easy to administer.
It is a non-discriminatory tariff which sometimes becomes inelastic to
adjust to the changing needs of the domestic industries.
b) Double-Column tariff:
Different tariff rates are charged for different countries in the Double-
Column tariff system. The double-column tariff system is divided into
two different types of tariffs: (a) General and conventional tariffs. The
legislature fixes the general schedule fixes the general schedule at the
very start while the conventional schedule is based on commercial
treaties with other countries. (b) There are two autonomously
determined schedules of tariff-the maximum and the minimum.
The minimum schedule applies to those countries who have taken the
MFN (most favoured nation) pledge or signed an agreement. The
maximum schedule applies to all other countries.
c) Triple-column tariff:
The triple-column tariff system consists of three autonomously
determined tariff schedules-the general, the intermediate and the
preferential. The general and intermediate tariff rates are like the
maximum and minimum rates mentioned above under the Double-
115
Free Trade versus
Protectionism Column tariff system. Preferential tariffs were once imposed between
nations and their colonies.
4) Classification based on Products:
Tariffs can be classified on the basis whether a product is imported or
exported. On this basis, the tariffs can be of two types:
a) Import duties and
b) Exports duties.
a) Import Duties:
If the home country imposes a tariff upon the products of foreign
countries as they are imported, the tariff is known as an import tariff or
import duty.
b) Export Duties:
Export duties are imposed on the commodities exported to be sold in
foreign market, it is called an export tariff or export duty.

6.2.2 Effective Rate of Protection

Tariffs can be imposed on both final goods and intermediate goods as well.
Tariffs on raw materials and intermediates impact the cost of production for
domestic industry. Thus, we must consider tariff on raw material while assessing
the extent of protection provided to the domestic industry in prevailing tariff
structure. The extent of protection granted to the domestic industry by the given
structure of nominal tariff rates is measured by the Effective Rate of protection
(ERP). Under free trade, value added in the domestic industry would be
determined by world market prices of the final good and imported inputs. And
thus, effective rate of protection will be same as tariff rate. Also, if production of
the final good does not need any intermediate goods, then the ERP equals the
nominal rate of tariff on the final good. When a tariff is imposed, domestic prices
can exceed the world market prices. Here, domestic value added and ERP would
depend on the extent of price increase of the final good vis-à-vis that of
intermediates along with the need of the intermediate goods in the production
process.
ERP measures the change in value added in the domestic industry due to tariff
protection. By definition,
ERPF = (VT-VW)/VW,
ERPF is the ERP on the final good F; VT is a value-added in the production of F
after tariff; and VW, is a value-added in the production of F at world market
prices, i.e. VW is the value added under 'free trade'. Remember, value added is the
difference between the price of the 'final good produced by an industry, less the
cost of inputs required per unit of production of the final good.
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Let us consider a few examples to understand the concept of ERP clearly. Instruments of
Protectionism
Consider a final good F whose world market price is Rs.10000. To produce one
unit of F, you require one unit of an intermediate good I, whose world market
price is Rs.5000. Thus Vw, in this case, is Rs.5000 (i.e. 10000-5000).
Case 1 Suppose a tariff of 20% is imposed on the final good F, while there is no
tariff on the intermediate, I. Assuming a small open economy, post tariff, the
price of F in the domestic market rises by 20% (to Rs.12000) and V T is Rs. 7000
(i.e., 12000-5000). Hence ERP is 40% [i.e. ((7000-5000) / 5000)* 100, which is
much higher than the nominal rate of protection of 20%.
Case 2 Suppose there is no tariff on the final good F and a tariff of 10% is
imposed on intermediate I. The small economy assumption means there will be
no change in the world market price of I after the tariff, while its domestic price
will increase by 10% (to Rs.5500). Now, VT is Rs. 4500 (i.e., 10000-5500) and
ERP is - 10% [i.e. ((4500 -5000) / 5000) * 100].
Following points can be kept in mind regarding ERP:
 if production of the final good does not need any intermediate goods, then the
ERP will be equal to the nominal rate of tariff on the final good.
 if the tariff on final goods is higher than that on intermediate goods, then the
ERP would be higher than the nominal rate of protection.
 ERP could be negative when tariffs on imports are too high compared to the
tariff on the final good. When ERP is negative, it means that tariffs are
reducing domestic value added as compared to free trade.
The measurement of ERP sometimes gets difficult because various inputs with
different tariff rates are used to produce one commodity. Some other limitations
of the concept of ERP is that it assumes fixed coefficients of production which do
not allow for factor substitution possibilities. Also, the assumption of small open
economy which cannot influence world prices is sometimes unrealistic.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Consider the following cases and describe whether ERP will be higher, lower
or equal to the nominal rate of tariff:
Case I: If the production of the final good requires no
intermediates:_______________
Case II: If the tariff on final goods is higher than that on
intermediates:______________
Case III: If the tariff on intermediate goods is higher than that on final goods.
117
Free Trade versus
Protectionism 2) Differentiate between Single column tariffs and double-column tariffs.
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3) List different categories of tariff barriers.

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6.2.3 Economic Impact of Import Tariff in partial equilibrium

analysis
Using Figure 6.1, we will examine the impact of a tariff on various economic
agents like consumers, producers and the government in a partial equilibrium
framework. We assume that the country is a small open economy that cannot
affect world market prices. This assumption implies that the tariff leaves the
world market price of the good unaffected while raising its price in the domestic
market. In Figure 6.1, we consider the domestic demand and supply curves of the
imported good. The world market price of the good is Pw, which would prevail in
the domestic market under free trade. Thus, with free trade, domestic production
of the good would be Q1, domestic demand Q2, and the difference Q1 Q2 would
be imported. A specific tariff rate of t per unit drives a wedge between the world
price and the domestic market price of the imported good. Post-tariff prices in the
domestic market rise to (Pw + t). As a result, domestic production increases from
Q1 to Q3 while consumption falls from Q2 to Q4.
Now let us consider the costs imposed by the tariff. Owing to the tariff, domestic
consumers suffer a loss in consumer surplus equal to the area (a + b + c + d),
compared to free trade. This loss arises because consumers must now pay a
higher price (Pw + t) for the good and also because they now consume Q4Q2
amount less of the good than with free trade. However, domestic producers gain
from the price rise, with the area representing the increase in producer surplus.
The government also gains from the tariff as it earns revenue. The imports are
now Q3Q4 units, each paying a tariff of t per unit, so the tariff revenue is given by
the rectangle with area c. The loss to consumers exceeds the gain to producers
and the government taken together, indicating that the tariff results in a net social
loss to society equal to the sum of areas b and d. In Figure 6.1, Area b measures
the loss in social welfare from the production distortion due to the tariff. It
represents the higher cost of producing Q1Q3 domestically rather than importing
this amount; Area d is the welfare loss due to the consumption distortion created
by the tariff. It represents the cost of not consuming Q4Q2, an amount whose
value to consumers exceeds the cost of importing it.
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You should note that our partial equilibrium analysis of the impact of a tariff Instruments of
Protectionism
focuses simply on the market for the imported good. Repercussions on several
important issues like terms of trade, BOP, factor markets etc., are left out of this
framework, as in the case of our analysis of the benefits of free trade. In
particular, our analysis does not attach any weight to employment in the sector
being granted tariff protection. If the import-competing sector accounts for a
significant share of total employment, the measures of welfare loss would have to
be adjusted accordingly. In reality, employment is often the most important
reason underlying the imposition of protectionist trade policies.
P
S

Pw +t

a b c d
Pw

D
B2
O
Q1 Q3 Q4 Q2 Q

Source: Figure 6.3 in Sikdar (2003)

Figure 6.1: Economic impact of Import tariff in a partial Equilibrium analysis

6.2.4 General Equilibrium Analysis: Impact of Tariff on Volume

of Trade and Terms of Trade (TOT)
When a country imposes a tariff, not only a specific product or sector but
every sector of the economy gets affected in one way or the other. Import
tariff changes the production and the consumption of other goods which in
turn affect the composition of production and the allocation of resources
across different sectors. Eventually, the volume of trade changes
correspondingly. Further, a change in the Volume of trade may change the
country's TOT (depending upon the size of the country and how the
government spends the tax revenue). Let us examine the impact of the tariff
on the Volume of trade and Terms of trade (TOT) in a small country and a
large country.
1) General Equilibrium Analysis of Tariff in a Small Country:
When the tariff-imposing country is small, the domestic price of the
importable commodity will rise by the full amount of tariff for the individual 119
Free Trade versus
Protectionism consumers and producers in that small tariff-imposing country. The
international price of the commodity will, however, remain unaffected. Let us
assume that a small economy produces two commodities: Machinery (being
imported) and textiles (being exported). When an import tariff is imposed, it
will increase the price of machinery, which will encourage domestic
production. But, if all the resources are fully employed, expansion in the
production of machinery will require contraction in the production of textiles.
Thus an import tariff will expand the machinery sector and contracts the
export sector. On the other hand, the higher domestic price of machinery will
shift consumption from machinery to textiles. Consequently, both the volume
of exports and the volume of imports will decline. Thus the Volume of trade
will fall.
Import tariff leads to welfare losses for a small country on two fronts: 1.
Import tariff reallocates the resources from exporting the commodity to
importing the commodity in which the country has a comparative
disadvantage. 2. It alters the consumption pattern of the consumers as they
have to pay a higher price for importing goods.
The general equilibrium analysis of tariffs in the case of a small country can
be understood with the help of Fig. 6.2.

Machinery P1
(Importable)
P2 R1
C1
R2
A C2
O1
E1 E
O

P1
B Textiles
(Exportable)

Figure 6.2: General Equilibrium Analysis of Tariff in a Small Country

In Fig. 6.2., the production possibility curve related to two commodities Textile
and Machinery is AB. Under the assumptions of CRS technology and
diminishing marginal productivities, PPF is drawn strictly concave downwards.
Initially, in the case of free international trade, P1P1 is the international exchange
ratio line and the production equilibrium point is E.
The consumption equilibrium point is R1 which lies on the community
120 indifference curve C1. In this situation, country A exports OE quantity of textiles
and imports OR1 quantity of machinery. If a tariff is imposed but the world prices Instruments of
Protectionism
of commodities remain the same, the international exchange ratio line is P 2E1,
parallel to the original international exchange ratio line P1P1.
Now production equilibrium shifts to E1 where country A produces a large
quantity of domestic machinery (importable goods). This is the production or
protective effect of tariffs. The consumption equilibrium shifts from R1 to
R2 where the international exchange ratio line P2E1 becomes tangent to a lower
community indifference curve C2.
It shows that tariff has caused a reduction in the welfare of the tariff-imposing
small country. The shift in consumption point from R1 to R2 signifies the
consumption effect of the tariff. After the tariff, the country exports the O1E1
quantity of textiles and imports the R2O1 quantity of machinery. Both exports and
imports are smaller than the free trade levels. Thus, tariffs for a small country is
welfare reducing.
2) General Equilibrium Analysis of Tariff in a Large Country:
For a large tariff-imposing country, a tariff changes its TOT along with VOT.
If the tariff-imposing country is large, reduced demand for imports due to
tariff imposition may reduce the world demand for the concerned commodity
to a great extent. Since the extent of reduced demand is high, it may reduce
the international price of the concerned commodity. Thus, the price of an
exporting commodity remains unchanged while that of importing commodity
falls. This will cause a change in the international price ratio and will bring an
improvement in the terms of trade of the tariff-imposing large country.
The production effect, consumption effect and terms of trade effect due to
tariff can be explained through Fig. 6.3. Continuing with the example in
Figure 6.2, a country produces two commodities: Machinery (being imported)
and textiles (being exported)
P
P2 1 R3
Machinery
C3
(Importable)
R1 C1
A R2
C2
O1 E 1
E

P1
B Textiles
(Exportable)

Figure 6.3: General Equilibrium Analysis of Tariff in a Large Country

121
Free Trade versus
Protectionism When a large country imposes a tariff, the World price of the importable
commodity falls (while the price of the exportable commodity is the same),
shifting the international exchange price line to P3E1. As you can observe in
Figure 6.3, price line P3E1 is steeper than the exchange ratio line P1P1 or P2E1. It
simply means that the country can now buy its imports cheaper and sell its
exports at the same price.
In this case, the production equilibrium occurs at E1 and consumption
equilibrium occurs at R3 where P3E1 becomes tangent to the higher community
indifference curve C3. The large tariff-imposing country imports R3O1 quantity of
machinery and exports O1E1 quantity of textiles. A higher ratio of imports to
exports indicates that the terms of trade have become favourable for the tariff
imposing-country A.
The large country experiences production or protective effect as the domestic
production of machinery increases owing to a shift in the production equilibrium
from E to E1. Although, increased domestic production required the reallocation
of resources the country has gained because of positive consumption and terms of
trade effects.
The large country also experiences a welfare effect despite a reduction in
specialisation and reallocation of resources towards import-substitute production.
The welfare effect is reflected in the shift of consumption equilibrium to the
highest community indifference curve C3. This is the positive consumption
effect. Thus, large country imposing tariff benefits from the favourable TOT,
despite the reduction in the volume of international trade.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Describe the economic impact of Import tariff in a partial Equilibrium
analysis.
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2) What is the Impact of tariff on the Volume of trade and Terms of trade (TOT)
in the case of a small country?
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3) Does a large country gain or lose from imposing a tariff? Justify. Instruments of
Protectionism
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6.3 EXPORT SUBSIDIES

Export subsidies are government policies that are implemented to encourage the
export of goods by incentivizing local producers through easy and cheaper loans,
direct payments, tax benefits etc. Like a tariff, an export subsidy can be either
specific i.e. a fixed sum per unit or ad valorem i.e. the proportion of value
exported. When the government provides an export subsidy, producers export up
to a point where the domestic price is greater than the foreign price by the
amount of subsidy. While export subsidies indeed help increase exports, there are
costs associated with them. The effects of export subsidies on producers,
consumers and the economy are explained in Figure 6.4

Price (P) S
Ps
a` b c d
Pw
e f g
Pa

Exports Quantity (Q)

Source: Figure 6.4 in Sikdar (2003)
Figure 6.4: Effects of an export subsidy
When a country provides subsidies to exporters, the price will rise from P w to Ps.
At the same time, the price in importing countries falls from Ps to Pa., thus the
price rise is less than the subsidy. In the exporting country, consumer loss is the
area a+b in Figure 6.4 as they have to pay higher. Producers' gain is reflected in
the area a+b+c; the government subsidy is the area b+c+d+e+f+g. The net
welfare loss is, therefore the sum of the area b+d+e+f+g. Also, unlike in the case
of tariff, export subsidies worsens the terms of trade by lowering the International 123
Free Trade versus
Protectionism price from Pw to Pa. This leads to additional terms of trade loss e+f+g. Thus,
export subsidy negatively affects the national welfare.
Table 6.1 Welfare Effects of an Export Subsidy

Exporting Country
Consumer Surplus − (a + b)
Producer Surplus + (a + b + c)
Govt. Revenue − (b + c + d + e+ f + g )
National Welfare − (b + d +e+ f + g )

6.4 NON-TARIFF BARRIERS

Besides tariff barriers, various non-tariff barriers are also prevalent in various
countries. Just like tariff barriers, non-tariff barriers also influence the global
economy by limiting free trade. Various non–tariff barriers include quantitative
restrictions like import quotas, Voluntary export restraints, Exchange controls,
Import deposit schemes, Health and safety standards, Customs valuation
procedure, Local content requirements etc. This section will discuss these non-
tariff barriers and their impact on the economy.

6.4.1 Import Quota

Import quotas impose direct restrictions on the quantum of imports into a
country.
In practice, quotas are administered through a system of import licenses. Only
license holders can import specified quantities of the imported goods into the
domestic market. When imports are limited, domestic demand for the good
exceeds domestic supply plus imports.
Thus, you will see that with a quota the domestic price of an imported good will
always be higher than its world market price. License holders buy the imported
goods at world market prices and then sell at higher prices in the domestic
market. Import quota raises the domestic prices by the same amount as a tariff
that limits the imports to the same level except when it is a monopoly in the
domestic market.
In what follows we will examine the impact of an import quota under different
market structures in the domestic economy. We first discuss the case of perfectly
competitive markets and then that of monopoly.
1) Import Quotas with Perfect Competition
Figure 6.5 demonstrates the effect of an import quota when markets are perfectly
competitive. D and S represent the demand and supply curves for the good before
124
quota imposition. Under free trade, the world price Pw prevails, total domestic Instruments of
Protectionism
production is Q1, demand is Q2, and Q1 Q2 amount is imported. Now suppose an
import quota is imposed, which restricts imports to Q1 Q3 (where, Q1Q3 < Q1Q2).
Immediately with quota imposition, at the world price P w, domestic demand falls
short of total domestic production plus imports. This excess domestic demand
drives up prices in the domestic market, till the market clears.

P
S
E S’
E’
P’
a
Pw b c d

O
Q1 Q4 Q3 Q5 Q2 Q

Source: Figure 6.5 in Sikdar (2003)

Figure 6.6: Effect of an import quota when markets are perfectly competitive
The quota effectively shifts the domestic supply curve to S', by the amount of the
quota. The economy moves to the new equilibrium E', where the price has risen
from Pw to P', domestic production has increased from Q1 to Q4 while domestic
demand has fallen from Q2 to Q5. At E', imports, restricted by the quota, are
equal to the amount Q4 Q5 (note that Q3Q1 = Q5Q4 = import quota). A tariff rate
equal to P'- Pw, is the tariff equivalent of the quota. It would have restricted
imports to the same level as the quota and had the same effect on domestic
prices. However, implementing the tariff equivalent of a quota may not always be
feasible, as the rate may be too high to be acceptable. You should see that in the
case of a tariff, a quota involves a loss in consumer surplus equal to the area (a +
b + c + d). This is offset by a rise in producer surplus equal to the area a. But an
important difference between tariffs and quotas arises from the fact that with a
quota the government does not earn revenues as in the case of a tariff. The area c,
therefore, does not accrue to the government, rather it represents the quota rent,
which may be captured by the import-license holders, who buy at the world price
Pw and sell at a higher price P', making a profit of (P' - Pw) per unit of imports. If
c accrues to the license holders and is counted as part of the social gain, then the
social loss from the quota is equal to the area (b+ d), the same as in the case of a
tariff.
Often foreign exporters have the right to sell directly in the domestic market. In
that case, the quota rent c would accrue to foreigners and it would be a social loss
from the domestic country's point of view.
125
Free Trade versus
Protectionism Another disturbing possibility, and one that is often observed in practice, is that
the quota rent may not accrue to license holders. Rather it may be dissipated in
rent-seeking activities, like paying bribes to acquire import licenses. In that case,
area c would be a social loss and the total cost imposed by the quota would equal
the area (b+c+d), which is more than in the case of an equivalent tariff.
Governments in developing countries have the option to auction import licenses.
A competitive bidding process would drive the price of licenses up to (P' - Pw)
per unit of imports and the government would earn revenue equal to the area c. If
this process worked smoothly, the effects of a tariff and quota would be
equivalent. However, sometimes, the auctions may not be competitive and
collusion among bidders might subvert the entire process.
2) Import Quotas with Monopoly
When there is a domestic monopoly, an import quota leads to a greater loss in
social welfare, as compared to perfect competition. We will see that in the
presence of a monopoly, an import tariff should be preferred to a quota from the
efficiency and social welfare point of view.
When there is a tariff t, imports are freely available at a price (P w + t). So the
monopolist cannot charge a higher price than this level, for if he did domestic
consumers would go for imports and his sales would be reduced to zero. Thus, a
tariff effectively imposes a price ceiling. However, with a quota, the monopolist
can charge a price higher than the import price. In this case, he will not lose his
entire market share, since imports cannot exceed the limit set by the quota. Thus
a quota preserves the monopolist's price-setting power to a large extent.
This argument is illustrated in Figure 6.6. Under free trade, D is the demand
curve facing the monopolist and the domestic price of the good is the world
market price, Pw. Suppose, an import quota is set, limiting imports to the amount
Q1Q2. With the quota, the demand curve facing the monopolist shifts inwards by
the amount of the quota, at all prices above Pw, because imports have reduced the
monopolist’s market by Q1Q2. Post quota imposition, the relevant marginal
revenue curve facing the monopolist is MR, corresponding to the new demand
curve.
In this situation, the monopolist will maximise profits by producing an output of
Qm, at which marginal revenue equals marginal cost. This output will be sold at
the price Pm, read off the demand curve. Now (Pm - Pw) is the tariff equivalent of
the quota or the quota rent earned by the import license holders. Note that with
perfect competition in the domestic market, the MC curve would have been the
supply curve, and the market price would have been P' and output, Q'. Clearly
with a monopoly the outcome is more inefficient, compared to perfect
competition. The monopoly output is lower (Qm < Q') and the price is higher
(Pm > P'), leading to greater welfare losses. From this analysis it should be clear
to you why tariffs are preferred to quotas, especially when the domestic producer
126
wields monopoly power. GATT negotiations have tried to phase out quantitative Instruments of
Protectionism
restrictions and replace quotas with tariffs.

Pm MC

P’

Pw
Q1 Q2
D
MR
O Qm Q’ Q

Source: Figure 6.5 in Sikdar (2003)

Figure 6.5: Effect of an import quota when the market is a monopoly

6.4.2 Voluntary Export Restraint

A variant of the import quota is the voluntary export restraint (VER), also known
as a voluntary restraint agreement (VRA). A VER is a quota on trade imposed
from the exporting country's side instead of the importers. This is a self-imposed
restriction on the quantity of a good permitted to export to another country.
VERs are export quotas negotiated by an importing country with its trading
partners. Under this, importing countries request other countries to voluntarily
lower their exports to protect domestic businesses. Under the negotiation,
exporting country voluntarily agrees to restrict the quantity of exports. VERs had
been a popular way for importing countries to protect their domestic industries
without going into a trade war with exporting countries.
Historically, it was used largely by developed countries on textiles, footwear,
steel, automobiles, etc to impose their own restrictions rather than facing tariffs
and quotas. It was one of the popular measures of protectionism during the
1980s. But the WTO members agreed to not use any new VERs in 1994. As per
many economists, Voluntary Export Restraints are ineffective over a longer
period. For instance, The U.S. automobile companies were facing more
competition from efficient Japanese automobiles so Japan imposed Voluntary
Export Restraints (VERs) on the exports of cars manufactured in Japan to the
U.S. but this non-tariff measure proved to be ineffective.
127
Free Trade versus
Protectionism In Uruguay's negotiation round, World Trade Organization (WTO) does not
prevent governments from imposing VERs on exporters through negotiation.
However, the governments of the importing and exporting countries are
sometimes able to convince exports to put VERs on the quantity of the exports. A
VER is always more costly to the importing country than a tariff that limits the
imports by the same amount.
Table 6.2 Summary of Impact of Tariff and quantitative restrictions on the
Economy
Tariff Export Import Quota Voluntary
subsidy export
restraint
Producer Increases Increases Increases Increases
Surplus
Consumer Falls Falls Falls Falls
surplus
Government Increases Falls No change No change
revenue (government (rent to (rent to
spending license foreigners)
rises) holders)
Overall Ambiguous Falls Ambiguous Falls
national (falls for a (falls for a
welfare small small
country) country)
Source: Krugman, P. R., & Obstfeld, M. (1997). International economics:
Theory and policy. Addison Wesley.

6.4.3 Other Non-Tariff Barriers

The following are some of the other important NTBs commonly used by
countries following protectionist policies:
1) Exchange controls:
Exchange controls are restrictions imposed by countries' Central Banks that
directly limit domestic residents' ability to acquire foreign currency in
exchange for domestic currency. For instance, one method of imposing
exchange controls involved acquiring the Central Bank's permission to hold
foreign currency bank accounts.
2) Import deposit schemes:
These are rules imposed by countries' Central Banks, which tend to restrict
imports by making them more expensive. For instance, under the rules
importers are required to deposit a certain amount (usually in proportion to
the value of the imported good) with the Central Bank, which effectively
128 raises the cost of importing.
 Instruments of
3) Health and safety standards: Protectionism
Often importing countries insist that imported goods meet certain minimum
health, safety and environmental standards. Meeting the standards would
raise costs for the exporting country. Presumably, the underlying motive for
standard imposition is to safeguard the health and general welfare of domestic
residents of the importing nation. However, in practice, these standards are
often used by developed nations to restrict imports originating from low wage
developing countries. For instance, faced with cheap manufacturing imports
from low-wage countries like Malaysia, Indonesia and Thailand, developed
countries now insist that these counties comply with certain minimum labour
and environmental standards, which would raise their production costs.
4) Customs valuation procedure:
Under this procedure, the importing country would artificially enhance the
value of the imported goods under some pretext, which would raise its duty
under a system of ad valorem tariffs. For instance, Sikdar (2003, p.141) cites
the example of the US valuing certain chemical imports at the 'American
selling price' (rather than at the 'invoice' price or the 'world market' price) in
the post-war period. However, this practice was discontinued since the Tokyo
Round of negotiations.
5) Local content requirements:
This is a practice followed especially in developing countries, which requires
that some stipulated portion of a final good be produced domestically. Or it
may be stated that a certain specified fraction of the final goods price must
represent domestic value added. The underlying logic is to promote the local
production of certain intermediate goods. From the importing firm’s
viewpoint, there is no restriction on imports. For they can import more, if
they also buy more from local firms. From the domestic intermediate
industries' point of view, a local content requirement provides trade
protection in the same way as an import quota.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the effects of an import quota, when there is perfect competition in
the domestic market??
………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….
129
Free Trade versus
Protectionism 2) What are the effects of an import quota, when there is a monopoly in the
domestic market?
………………………………………………………………………………….

………………………………………………………………………………….
3) List various non-tariff barriers that countries use to restrict trade flows.
………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….
4) What do you mean by Voluntary Export restraints?
………………………………………………………………………………….

………………………………………………………………………………….

………………………………………………………………………………….

6.5 LET US SUM UP

After understanding the theories of protectionism in the previous unit, we
discussed various instruments countries use to protect their domestic industries
from free trade and international competition. We discussed tariffs and various
non-tariff barriers to trade in this unit.
In this unit, we discussed various categories of a tariff like import tariffs, export
tariffs, Specific tariffs, Ad Valorem tariffs, Compound tariffs, revenue tariffs,
protective tariffs, Single-Column tariffs, Double-Column tariffs and Triple-
Column tariffs. We also discussed the effective rate of protection, which
measures the extent of protection granted to the domestic industry by the given
structure of nominal tariff rates. Tariffs on raw materials and intermediates would
raise the cost of production for domestic industry and will affect the effective rate
of protection vis-à-vis nominate rate of tariff.
We also discussed the economic impact of Import tariffs in partial equilibrium
analysis on various economic agents like consumers, producers and the
government. We found out that while tariff increases producer surplus and
government revenue, it hurts consumer surplus. We also examined the impact of
the tariff on the Volume of trade and Terms of trade (TOT) in general
equilibrium analysis in the case of a small country and a large country. Overall
the national welfare falls for the small country.
We also discussed Export subsidies as government policies that are implemented
to encourage the export of goods by incentivizing local producers through easy
and cheaper loans, direct payments, tax benefits etc. We analysed its impact on
the economy and compared it with the effect of the tariff on the economy. We
analysed that while export subsidy is beneficial for the producer, it hurts
130
Consumer surplus and government revenue. Overall, export subsidies negatively Instruments of
Protectionism
affect the overall national welfare.
We also discussed quantitative restrictions like import quota and Voluntary
export restraints and their impact on the economy. We identified that import
quota and VER increase producer surplus and reduce consumer surplus. We also
discussed about other non-tariff barriers like exchange controls, import deposit
schemes, health and safety standards, customs valuation procedure and local
content requirements
We also identified that tariffs lead to more efficient outcomes compared to non-
tariff barriers like quotas, as in addition to restricting the flows of imported
goods; tariffs also impose a price discipline on domestic firms. Further, while the
government directly benefits from tariff revenues, the quota rent may be
completely dissipated in wasteful rent-seeking activities, leading to a social loss.

6.6 KEY WORDS

Consumer Surplus The gain to consumers when the price they
are willing to pay for a given quantity of a
good exceeds the amount they have to pay
for that quantity.
Effective Rate of protection (ERP) It measures the extent of protection granted
to the domestic industry by the given
structure of nominal tariff rates.
Free Trade When countries engage in international
trade without imposing any policy
restrictions on the free flow of goods and
services across international boundaries.
Non-tariff barriers A non-tariff barrier is any measure other
than a customs tariff, that acts as a barrier to
international trade.
Perfect Competition Perfect Competition is a market condition
characterised by perfect information among
buyers and sellers. It consists of a large
number of firms that are price takers and
who sell a homogeneous product to a large
number of buyers.
Producers Surplus The gain to producers arises from the
difference between the minimum price at
which they are willing to supply a given
quantity of a good and the price they
receive by selling that quantity in the
market. 131
Free Trade versus
Protectionism Quota A quantitative restriction on the quantum of
imports is permissible that is often
administered via the distribution of import
licenses.
Tariff A tax imposed on imported goods raises the
price of such goods in the domestic market.
Terms of Trade The ratio of the price received for a
country's exports to the price paid for its
imports.
Voluntary export restraint It is a self-imposed trade restriction at the
request of the importing country whereby
an exporting country limits the number of
goods of a particular nature that it can
export to a specific country or region.

6.7 SOME USEFUL REFERENCES

Acharyya, Rajat (2014). International Economics: An introduction to theory and
policy. Oxford University Press. Chapters 9 and 10.
Cherunilam, Francis (1997). International Economics. Tata McGraw-Hill
Publishing Company Ltd. Chapter 10.
Krugrnan, P. and M. Obstfeld (2000). International Economics: Theory and
Policy, Addison Wesley Longman: Singapore. Chapters 8, 9 and 10.
Salvatore, D. (2004). International Economics, Eighth Edition, John Wiley &
Sons: Singapore. Chapter 8.
Sikdar, S. (2003). Contemporary Issues in Globalisation: An Introduction to
Theory and Policy in India, Oxford University Press: New Delhi. Chapter 6.

6.8 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check your progress 1
1) Case I: Equal, Case II: Higher. Case III: Lower
2) The Single-Column Tariff also known as the uni-linear tariff system
provides uniform tariff rates to all the commodities irrespective of the
country of origin while in the Double-Column tariff system, different tariff
rates are charged for different countries.
3) Refer to section 6.2.1

132
Check your progress 2 Instruments of
Protectionism

1) Refer to section 6.2.3

2) Refer to section 6.2.4
3) Refer to section 6.2.4

Check your progress 3

1) Refer to section 6.4.1
2) Refer to section 6.4.1
3) Refer to section 6.4.3
4) Refer to section 6.4.2

133
Free Trade versus
Protectionism

134