3.4 Trade policy analysis using supply and demand

Trade policies like tariffs, subsidies, and quotas alter market outcomes by shifting supply and demand curves, which changes prices, quantities, and the distribution of welfare among producers, consumers, and governments. Analyzing these shifts with standard supply and demand diagrams is one of the most practical tools you'll use in trade policy analysis.

Trade Policy Analysis Using Supply and Demand

Supply and demand in trade policies

Trade policies work by shifting either the supply or demand curve in a domestic market, creating a new equilibrium price and quantity.

• Tariffs and quotas restrict imports, which effectively shifts the supply curve to the left. With less total supply available, the domestic price rises.
• Subsidies to domestic producers lower their costs, which shifts the supply curve to the right. More is produced at every price level, pushing the domestic price down.

The size of the shift depends on the size of the intervention. A 25% tariff shifts supply further left than a 5% tariff. A generous production subsidy shifts supply further right than a modest one. In each case, the new equilibrium sits at the intersection of the shifted supply curve and the (unchanged) demand curve.

Effects of tariffs, subsidies, and quotas

Tariffs

A tariff is a tax on imported goods. On a supply and demand diagram, it raises the effective price of imports, which pushes the domestic price above the world price.

• Domestic price rises by some or all of the tariff amount
• Quantity of imports falls as consumers buy less and domestic producers supply more
• Domestic producers expand output (import substitution)
• Consumer surplus shrinks; producer surplus grows

Subsidies

A production subsidy pays domestic firms to produce more, lowering their costs and shifting supply right.

• Domestic price falls, benefiting consumers
• Domestic production increases as firms respond to the cost reduction
• If the good is exported, export volume may rise (export promotion)
• Both consumer and producer surplus can increase, but the government bears the fiscal cost

Quotas

A quota sets a hard cap on the quantity of imports allowed into the country. The effects look similar to a tariff on the diagram, but the mechanics differ.

• Domestic price rises because supply is artificially restricted
• Imports fall to exactly the quota limit
• Domestic producers expand output to fill the gap
• Consumer surplus shrinks; producer surplus grows
• Quota rents arise: the difference between the higher domestic price and the world price, earned by whoever holds the import licenses. These rents go to license holders rather than the government (unless licenses are auctioned)

Distributional impacts of trade policies

Different groups win and lose depending on the policy instrument.

Producers benefit from tariffs and quotas because higher domestic prices and reduced foreign competition let them sell more at better margins. Subsidies also help producers by lowering their costs directly.

Consumers lose under tariffs and quotas because they pay higher prices and consume less. Under subsidies, consumers gain from lower prices and greater availability.

Government revenue varies by instrument:

• Tariffs generate tax revenue equal to the tariff rate multiplied by the quantity of imports: $\text{Tariff Revenue} = t \times Q_{\text{imports}}$
• Subsidies cost the government money, equal to the per-unit subsidy times the quantity produced: $\text{Subsidy Cost} = s \times Q_{\text{produced}}$
• Quotas generate no direct government revenue unless import licenses are auctioned off

Welfare analysis of trade policies

Welfare analysis uses consumer surplus, producer surplus, and government revenue to measure the total impact of a policy.

Consumer surplus decreases under tariffs and quotas (higher prices, less consumption) and increases under subsidies (lower prices, more consumption).

Producer surplus increases under all three instruments. Tariffs and quotas raise the price producers receive; subsidies lower their costs.

Deadweight loss is the key concept here. It represents the efficiency cost of distorting the market away from the free-trade equilibrium.

• Tariffs create two triangles of deadweight loss on the diagram: one from the production distortion (inefficient domestic firms producing instead of cheaper foreign firms) and one from the consumption distortion (consumers buying less than they would at the world price).
• Quotas create the same two deadweight loss triangles. The difference is that the revenue rectangle goes to quota-rent holders instead of the government.
• Subsidies create deadweight loss by encouraging overproduction beyond the efficient level. Resources flow into the subsidized industry that could be used more productively elsewhere.

Net welfare effect:

• Tariffs and quotas reduce total domestic welfare. The gains to producers and (for tariffs) government revenue are smaller than the losses to consumers, leaving a net loss equal to the deadweight loss.
• Subsidies have an ambiguous net effect. The combined gains to consumers and producers may or may not outweigh the government's fiscal cost, depending on the subsidy's size and the elasticities of supply and demand.