Ways to Allocate Import Licenses

The welfare effects on an import quota further depend on how the government allocated the legal rights to import. Whoever gets these rights without paying for them. Here are the main ways of allocating import licenses:

1. Competitive auctions – the best and rarest way

The government can auction off import licenses on a competitive basis, either publicly or under the table. The public auction might work as follows.

2. Fixed favoritism – the most arbitrary way

Import licenses adding up to the legal quota can also be allocated on the basis of fixed favoritism with the government simply assigning fixed shares to firms without competition or applications or negotiations. One common way of fixing license shares is to give established firms the same shares they had of total imports before the quotas were imposed.

3. Resource-using application producers – the least efficient way.

Instead of holding an auction, the government can insist that people compete for licenses in a non price way. One common but messy, alternative is to give import licenses on a first-come, first-served basis each month or each quarter.

GATT supposedly outlawed quotas for manufactured goods decades ago, but they are in fact increasingly common in the form of so-called "Voluntary Export Restraints" (VERs). Under a VER arrangement, the importing country does not maintain a limit on the amount to be imported, but exporting countries voluntarily limit the volume being sent out to an agreed-upon level. Exporting countries often agree to maintain VERs out of fear that failure to do so will lead the importing country to adopt far more severe measures. The U.S. Office of the Special Trade Representative often negotiates VERs with exporting countries while the Congress is considering prohibitive limits on imports, and the successful negotiation of the VER is then used to convince the Congress that the more severe measures are not necessary. The VER system also has some particular advantages for exporting firms, which will become clear in the discussion of Figure 2.

This graph is quite similar to the earlier presentation (Figure 1) for a tariff. The line segment Q₁-Q₂ represents the volume allowed into the country, so the domestic supply curve begins again to the right of that volume. Areas a and a' are the increase in producer surplus for the domestic industry, and areas b and d are the

FIGURE 2 The effects of a quota: partial equilibrium, small-country case.

same deadweight losses that appeared earlier. The effects on the price of the product, domestic consumption, and domestic production are similar to those depicted in Figure 1.

Area c, however, is different. If a tariff is maintained, that area is government revenue that can be used to satisfy public purposes or to allow the reduction of other taxes. Under a quota, however, that money goes to whoever is fortunate enough to have the right to ship the product from the exporting to the importing country. If quota rights are allocated to importers, they receive the windfall profit. If, for example, oil can be purchased on the world market at $1.50 per barrel and shipped to the East Coast of the United States for $0.75 per barrel for a total landed cost of $2.25 when a U.S. quota is being used to protect an internal price of approximately $3.50, those allowed to bring oil into the United States receive a gift of $1.25 per barrel. They land oil here at a cost of $2.25, and it is immediately worth $3.50. This example is not accidental; it was the situation prevailing from the 1950s into the 1960s in this country, and it produced enormous monopoly rents for the major oil companies that were allocated quota rights by Washington.

In the case of a VER, however, it is the exporting country that limits the volume shipped, and it can allocate the rights and determine who gets the windfall profits. In this case the bonanza goes to exporting firms rather than to importers, which explains why exporting countries often accept VERs. The VER on Japanese cars that limited sales in the United States to 1.85 million cars per year during the early 1980s had the effect of raising U.S. car prices by almost $1000 per car.[3] That meant an additional profit of about $1.85 billion per year for the Japanese car companies. They were forced to reduce sales here but were compensated through a gift of almost $2 billion per year, with the Japanese government deciding how the money was to be divided among the firms.

If the U.S. government had auctioned the quota rights to the highest bidder, the Treasury would have recaptured the monopoly rents through the auction revenues. If the international market for cars and therefore the auction were competitive, firms would bid approximately the area of the windfall profit rectangle for the right to bring cars into this market. Such auctions are held in some countries, but it is much more common for governments to allocate these valuable rights arbitrarily, which creates obvious opportunities for graft and corruption. The allocation of quotas can be a source of bribery if importers (or exporters in a VER) offer money to government officials in charge of deciding who gets the rights. Political campaigns can be financed by promising later allocations to those who contribute now.

The Multi Fibre Arrangement (MFA) in textiles and garments is probably the world's largest quota system, and it allows exporting countries to decide which firms will sell what quantities in the U.S. market. During a recent visit by one of the authors to a cotton spinning mill in India, the owner said that a spool of yam was worth $10 if it could be exported under an MFA quota, but only $8 if it had to be sold in the domestic market. Quota rights are extremely valuable, and it is hardly surprising that their allocation can be the sows of corruption. If the rights were auctioned in a competitive market, this problem would disappear and the operations of a quota would resemble those of a tariff, but such auctions are rare.

Quotas also create a problem of lega1 evasion, for exporters can resort to a number of strategies to reduce their protective effects. First, they can upgrade the product to sharply increase revenues and profits from a given volume that can be exported. During the period in which Japanese firms were limited to selling 1.85 million cars per year in the United States, for example, virtually all of the cars exported to the United States were top of the line models and had a variety of expensive options. U.S. firms were left with the less profitable lower end of the market. In addition, exporting firms can send major components for final assembly in the importing country, since such components are not subject to the quota. So-called screw driver factories are set up to do the final assembly of these products.

Finally, if quotas are assigned to an exporting country, products may be shipped to an intermediate stop, where they are relabeled and then sent on to the final market outside the quota. Indian manufacturers, for example, have been known to send 90 percent completed garments to Nepal or Mauritius, where the final work is done. They are then labeled as being from Nepal or Mauritius, and are sent to the United States outside of India's MFA quota. U.S. authorities eventually stop such imports, but by then the Indian exporters have found another small country from which to operate.

Subsides

Domestic production can also be increased and imports reduced through the use of a production subsidy.

We show this case in Figure 3, which represents exactly the same initial situation as in Figure 1. If a subsidy equal to S (per unit) is paid to producers in Country A, their supply curve shifts from S to S’ because the subsidy reduces average and marginal cost of production, and they will expand output to OQ₂. Since the price of oats in Country A remains at Pw, consumers continue to purchase OQ₄, and imports are Q₂Q₄. Because the price of oats remains unchanged at Pw, the loss of consumers' surplus does not occur. The subsidy to domestic producers must be included in government expenditure, however, and may be treated as a transfer payment to producers from the restofthe economy. The amount of the subsidy appears in Figure 3 as area a plus area b. Taxes in that amount must be levied to pay it. Area a is a pure transfer from taxpayers to producers, but area b involves the same inefficiency in resource use as before and can therefore be regarded as a deadweight loss. Since the subsidy does not reduce consumption, however, we avoid the other

Quantity of oats

FIGURE 3 The effect of a subsidy: partial equilibrium, small-country case.

part of deadweight loss (area d in Figure 6-1). The conclusion is that a production subsidy is preferable to a tariff on welfare grounds: It has a smaller deadweight loss, and it leaves codsumption unchanged.

Although subsidies are a less inefficient means of increasing domestic output, they are relatively uncommon because they arc politically unpopular. A tariff raises money for the government, and a quota appears to be costless, but the taxpayers have to provide the funds for a subsidy. The benefits of a subsidyinthe form of a lower price to consumers are frequently not understood by voters who instead object to the resulting expenditure of public funds. The domestic industry does not want to be seen as the recipient of a public handout and instep prefers a tariff or quota (particularly if it is allocated the import rights) whichis a more indirect and less obvious form of public support. Subsidies are the least inefficient method of encouraging domestic output, but they are also the most unpopular.

The large-country case

Returning to the subject of tariffs, we can extend the earlier partial equilibrium analysis to deal with the case in which Country A is large enough to influence the

world price when it changes the amount of its imports of a given commodity, such as oats. To deal with such a case we will assume a two-country worldinwhich both

Quantity of oats Quantity of oats

Figure 4 The effect of a tariff- partial equilibrium, large-country case.

countries, A and B, are producing and consuming oats. We continue to ignore the effects of any change on the rest of the economy (i.e., outside of the oats industry).

In Figure 4 we show demand and supply curves for both countries, A and B. The only novel aspect of this diagram is that the quantity axis for Country B runs from right to left. The vertical axis representing price is the same for both countries. Country A’s demand and supply curves are drawn in the conventional manner, but Country B's demand curve slopes downward from right to left, and its supply curve slopes upward from right to left. The reason for this construction is that we measure quantity for Country B from the origin, O, in a leftward direction. (To visualize the construction of this figure, the reader might imagine drawing Country B's demand and supply curves in the conventional manner and then, with a hinge along the vertical axis, flipping the figure over from right to left.)

Note that if no trade in oats were allowed, so that both countries were self-sufficient, the price of oats would be higher in Country A than in Country B. (The market-clearing price in each country would be the price at which the supply and demand curves intersect.) When trade is allowed, therefore, Country A will import oats from Country B.

In free-trade equilibrium, two conditions must be satisfied: Country A's imports must equal Country B's exports, and the price must be the same in the two countries. Graphically, we can visualize the determination of that equilibrium position by sliding a horizontal price line down the diagram until the point is reached at which Country A’s excess demand exactly equals Country B's excess supply. In Figure 4, this free-trade equilibrium price is Pw. Country A’s imports, Q₁Q₄, exactly equal Country B's exports, q₁q₄.

Now suppose that Country A imposes a specific tariff on its imports of oats, a tariff equal to T per bushel. What will be the effect on price in the two countries? We know that in the new equilibrium the price in Country A will exceed the price in Country B by the amount of the tariff. But to reach this new equilibrium the price will rise in Country A and fall in Country B. It is clear that we cannot simply add the tariff to the initial world price, because at such a price, Pw+T, Country A will import less than Country B is willing to export at the price Pw.

Once again, two conditions must be satisfied: Country A's imports must equal Country B's exports, and the price in Country A must exceed the price in Country B by exactly T. As before, we can graphically find that point by sliding a price line down the diagram (the price line now has a step in it, a differential equal to T) until B's exports equal As imports. In Figure 4, that point is reachedattheprice Pb in Country B and Pb + T in Country A, with B's exports, q₂q₃, equalto A’s imports, Q₂Q₃.

Using the right-hand side of Figure 64, we can now examine the effects the tariff on Country A in the same way that we did for the small-country case. The price of oats has risen in Country A, but not by as much as the tariff,and it has fallen in Country B. The higher price in Country A stimulates domestic production, which rises from OQ₁ to OQ₂, and reduces consumption, which falls from OQ₄ to OQ₃. Imports fall from Q₁Q₄ to Q₂Q₃. The welfare effects are exactly the same as before, except that we must be careful to show tariff revenue in Country A as the tariff times the new level of imports (Q₂Q₃)- Tariff revenue is larger than area c, representing the portion of consumers' surplus lost in Country A when the price of oats increased; it also includes area c. What this means is that the foreigner (Country B) is being made to bear some of the burden of the tariff.

How the tariff will be divided between a price rise in Country A and a price decline in Country B depends on the elasticity of demand and supply in the two countries. We will consider t few polar cases to illustrate this relationship.

First, suppose that Country B's supply curve in Figure 4 is perfectly elastic. In that case, the price in Country B remains unchanged when Country A imposes a tariff, and the price in A rises by the full amount of the tariff. This is the case in which Country A is a small country, already discussed in the previous section. The tariff does not affect the price: the terms of trade remain unchanged.

Second, suppose that Country B's supply curve is perfectly inelastic (it is vertical in the relevant range) and that Country B has no domestic demand forthe commodity it produces. This latter assumption may seem a bit odd, but it is a fairly close approximation to reality for a number of primary-product exporters. (Forexample, Malaya consumes a negligible amount of tin, its major export; Bolivia’s domestic consumption of copper is a tiny fraction of its production.) Alternatively we could assume that Country B's supply and demand are both perfectly inelastic. We show this case in Figure 5. Initially, with free trade, price is Pw andCountry A imports Q₁Q₂. Now when Country A levies a tariff on its imports of the commodity, the price in Country B simply falls by the full amount of the tariff. The price in Country A remains unchanged. The reason for this result is that producers in Country B are unwilling to reduce the amount they export when the price falls. Since the price in Country A is unchanged, that country's imports are unaffected by the tariff. In effect, the entire tariff revenue collected by Country A (area f in Figure 5) is paid by Country B's producers, whose export proceed are reduced by exactly that amount. This is called "making the foreigner pay thetax." and it means that the tariff has caused the terms of trade to turn against Country B.

We might expect countries in the position of Country B to object in this situate, and so they do, but oddly enough the loudest complaints often come from countries in the position of Country A. More specifically, producers in Country A complain because the tariff has had no protective effect: It has not reduced imports or increased

FIGURE 5 Making the foreigner pay the tariff: inelastic foreign supply.

the price in Country A; consequently, A's producers have not obtained any increase in producers' surplus.

In such circumstances, the producers in Country A are likely to advocate the use of a quota instead of a tariff. Because it sets a physical limit on the quantity of imports, a quota will reduce the supply of imports and cause the price in Country A to rise. The certainty of this result is a principal reason why many U.S. industries have urged the use of quotas instead of tariffs as a means of protecting them from import competition. Thus in this case we find that the effect of a tariff and a quota arc not identical. It may be, however, that there exists a tariff large enough to reduce imports and thus to stimulate domestic output in Country A by the same amount as our quota.

Another interesting point to note about this example is that the tariff could be levied equally well by the exporting country, B. The only difference—an important one—is that the tariff revenue would then accrue to Country B's government instead of Country As. Country B would be taxing away a part (area g) of the export proceeds. Such export tariffsare common in many developing countries where income taxes and other forms of taxation are difficult and costly to administer. It is often very easy and convenient to levy a tariff on a few highly visible export commodities, the trade in which is concentrated in one or two major seaports.

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