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Government Tariffs, Quotas, and Other Trade Restriction
Lecture 6


Why Government Intervenes in Free Trade?


  1. Rapid Growth of Trade

    1. GATT/WTO – many countries reduced trade barriers and tariffs

      1. Trade agreements

      2. European Union (EU)

      3. North Free Trade Agreement (NAFTA)

    2. Cheaper transportation and communications costs

    3. Growth of multinational corporations and international banks

      1. Multinational corporation operates in two or more countries

      2. Corporations move products, services, and resources cross a country’s borders

      3. International banks move the money cross a country’s borders

      4. Economies of scale – corporation creates department to keep up with a country’s legal system

        • Very difficult for a partnership or proprietorship to do.

  2. Why countries intervene in trade?

    1. Protect an eroding advantage

      1. U.S. had manufacturing while China is gaining manufacturing

      2. Call to protect U.S. manufacturing

    2. Keep inefficient industries operating

      1. Keep employment high

      2. Workers pay taxes, etc.

    3. Protect national security

      1. Energy – petroleum

      2. Agriculture

    4. Infant industry – country helps a new industry grow and thrive

    5. Protect national health

      1. China – produced harmful products

      2. U.S. beef – use hormones

    6. Intervene in foreign exchange rate

      1. Asian Tigers and China

      2. Weaken their currency

        1. Hurts import industry

        2. Imports are more expensive

        3. Expands export industry

        4. Creates wealth and jobs

      3. United States

        1. Maintains strong currency

        2. Hurts exports; encourages imports

        3. U.S. dollar is international currency

        4. U.S. gov. has to keep dollar strong to attract investors

    7. Increase tax revenue

      1. Collect tariffs and export taxes

      2. Easy to monitor ports

    8. Prevent export of high technology

    9. Retaliate against another country

Blue arrow Government usually wants its industries to export products to foreign countries. Its industries expand production and create jobs, and more money flows into country than out.

Government could lie and make one of the above claims in order to protect its industries.


Free Trade


Expand supply and demand equations to include free trade.

  • Free trade
    • Country imports or exports without any government restrictions
    • Large country can impact trade and prices

Country imports from international market

  • No Trade.
    • Market price and quantity are P*, Q*, and no imports.
  • Free Trade
    • Define Excess demand function (ED)
      • Excess demand = Demand function - Supply function
        • Has to be greater than or equal to zero
      • Regular supply and demand are domestic market
      • Excess demand is the demand in the international market
    • Country imports from international market
    • Domestic consumers pay lower price, PI and consume QT
    • Country imports, QT - QD, for price PI.
      • The import is also T' in the international market
    • Domestic industry contracts
      • Lower output
      • Industry employs less workers
    • Money flows out of country

This graph appears redundant. However, this method allows for some very complicated trade restriction analysis.

Free Trade - Imports
Economic impact of free trade

Country exports to international market

  • No Trade.
    • Market price and quantity are P*, Q*, and no exports.
  • Free Trade
    • Excess Supply (ES)
      • Excess Supply = Supply function - Demand function
        • Has to be greater than or equal to zero
      • Regular supply and demand are domestic market
      • Excess supply is the supply function in the international market
    • Domestic consumers pay higher price, PE and consume QD
    • Country exports, QT - QD, for price PE.
      • The exports are T' in international market
    • Domestic industry expands
      • Higher output
      • Hires more workers
    • Money flows into country


Free Trade - Exports
Economic impact of free trade

Below is free trade between Kazakhstan and United States

  • Let this be the petroleum market
    • United States imports Q*2 - Q*1
      • U.S. domestic demand and supply are Dm and Sm
      • U.S. produces Q*1 petroleum, but consumes Q*2
    • Kazakhstan exports Q*4 - Q*3
      • Kazakhstan domestic demand and supply are Dx and Sx.
      • Kazakhstan produces Q*4, but only consumes Q*3
    • International market
      • Excess demand (ED) function
      • Excess supply (ES) function
      • Imports = Exports = T
    • The petroleum price is P*
    • Note - T looks larger than imports and exports; this is my mistake, because I used Microsoft paint


Free Trade Between Kazakhstan and United States
Free trade between U.S. and Kazakhstan


Government Tariffs, Quotas, and Subsidies


Government Restrictions

  1. Tariff - a tax on each unit imported
  2. Quota - government establishes the maximum amount that can be imported.
  3. Subsidy - government subsidies export


  • Free Trade.
    • Market price is P' and amount imported is T
  • Government imposes a tariff
    • Government imposes a tariff of PT - PI
    • Domestic consumers pay higher price, PT and consume less.
    • Domestic producers expand production.
      • Expand production
      • Employ more workers
    • Country decreases imports for price PT.
    • Foreign producers sell for PI and export less
    • Government Revenue
      • Green box
    • Deadweight Loss
      • Red triangle
    • Lower social welfare
Government Tariff
Economic impact of a tariff
  • Government quota
    • If government imposes a quota
    • Same impact on market
    • One difference
      • Government does not collect revenue
      • Green area goes to foreign exports as "rent"
      • Rent
        • Long-run profits
        • Market competition drives profits to zero
        • However, rent is special term to indicate a market advantage to someone.


  • Government Export Subsidy
    • Free trade market price is P' with T quantity is exported
  • Government institutes an export subsidy
    • Government pays a subsidy of PE - PI per unit
    • Domestic consumers pay higher price, PE and consume less
      • Subsidy causes higher market price within the country
    • Country exports more
      • Quantity increases in international market
    • Foreign producers pay a cheaper price, PI and import more
    • Domestic industry expands
      • Higher output
      • Industry employs more workers
    • Government Subsidy
      • Yellow area + Red triangle
    • Deadweight loss of subsidy
      • Red triangle
Government Export Subsidy
Economic impact of an export subsidy


Blue arrow This is also called "Beg-thy-neighbor" policy. A government imposes a trade restriction to boost its industries at the expense of exporting country. Trade restrictions tend to lower international prices, harming exporting countries. Thus, some countries will retaliate with their own trade restrictions.

This analysis can be applied to other government trade restrictions

  • Manipulate the exchange rate
    • Government weakens or strengthens its currency
  • Import subsides
  • Export tax
  • Supply reduction
    • Government has programs to reduce production in domestic industries
    • Increases prices and profits.

Asian Tigers


Highly regulated, highly taxed economies tend to grow slowly, while countries with free, competitive markets tends to grow quickly.

Note - Some totalitarian states can growth fast, but the high growth rate is temporary. For example, the Soviet Union grew extremely fast during the 1960s as it was expanding and adding cities and factories. However, by the 1980s, it looked like the Soviet economy stagnated. (If I am wrong, then please correct me).

Note - Currently Venezuela is growing fast under the leadership of Hugo Chavez. Venezuela is an petroleum exporting country and a member of OPEC. President Chavez is using the revenue from petroleum to finance this growth.

  1. Asian Tigers - Hong Kong, Singapore, South Korea, and Taiwan

    1. Free competitive markets

      1. GDP grows approx. 10% per year

      2. Business oriented

    2. Do not have abundant resources

      1. Country creates a pro-market legal structure

      2. The only strategy

      3. Resource abundant countries – create complicated, highly regulated societies

        1. Tend to grow slowly

        2. Dutch Disease

          1. Resource rich countries attract foreign investment

          2. Currency appreciates

          3. Puts export sector at a disadvantage

    3. Pursue export-oriented polices

      1. Open to international trade

      2. Weaken its currency

      3. Export industries grow large

        1. Creates jobs and wealth

        2. Factories build large, economies of scale

        3. Supplying an international market

    4. People have savings rate

      1. Put money into banks

      2. Banks lend to businesses

      3. Businesses invest in machines and equipment

    5. Have high education levels

      • Emphasize vocational and technical training


Dollar, David. 1992. "Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985." Economic Development and Cultural Change 40(3): 523-44.

Lim, David. 1994. "Explaining the Growth Performances of Asian Developing Economies." Economic Development and Cultural Change 42(4): 829-44.


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