Tariffs and Quotas:
A Supply-and-Demand Analysis

A modified supply-and-demand graph can demonstrate the effects of tariffs and quotas on US producers and consumers through showing what happens to prices, imports, exports and production under various trade policies. It’s appropriate any time the nation under consideration doesn’t have a significant impact on the world market of the good. (For example, it wouldn’t work for Saudi Arabia and oil, or Columbia and coffee.) But it is very useful for many goods in many nations. We’ll go over it step by step below. First, as a warning to those with some familiarity with supply and demand: This is a modified S&D analysis. It is not quite the same as the S&D you’re familiar with, so pay attention!

The Teddy Bear Market
Figure 1 at right shows the domestic supply and demand of teddy bears, which are traded internationally. On the vertical axis is the price. The horizontal axis measures quantity. But this is where people familiar with regular supply-and-demand analysis have to be careful: This graph does not say that the price of bears will be \$55, and it does not say that the quantity of bears will be 75. Nothing is pushing the price or quantity of bears toward the intersection of these curves, because they show only a part of the market: They show U.S. supply, but other countries also supply. They show U.S. demand, but there are demanders in other countries too. The only thing the intersection point shows is that if the price were \$55, then domestic suppliers could meet all the domestic demand. We wouldn't have to import any bears, and we wouldn't have any left over to export. So at that price (\$55), we would read the graph this way:

• U.S. consumers who actually get teddy bears are on the upper portion of the demand curve, because they're willing and able to pay at least the \$55 price. (For example, the 20th consumer is willing and able to pay up to \$110 for one.)

• U.S. consumers who don't get teddy bears are on the lower portion of the demand curve, because they're not willing and able to pay the \$55 price. (For example, the 100th consumer is willing and able to pay no more than \$30 for one.)

• U.S. firms who actually make and sell teddy bears are on the lower portion of the supply curve, because their costs are less than the price. (For example, the firm manufacturing the 45th teddy bear can make it at a cost of \$40.)

• U.S. firms who don't make and sell teddy bears at the going price are on the upper portion of the supply curve, because their costs are above the price. (For example, there is a firm that could manufacture a 95th teddy bear, but could do so only at a cost of \$65.)
• ! Now you're ready to try Question #1 on the Tariffs & Quota exercise.

The Possibilities for International Teddy Bear Trade
We can also work with the graph to show that whenever the world price is above \$55, U.S. firms will want to supply more teddy bears than U.S. consumers want. If we trade internationally, these “excess” teddies can constitute our exports. When the world price is below \$55, fewer U.S. firms will be able to manufacture at the lower cost required to produce profitably, but more U.S. consumers will be willing and able to buy them. Those “missing” teddies U.S. consumers want but U.S. firms can't make can be imported.

Exporting Teddy
What if the world price of teddy bears is not \$50, but \$70? In order to see this case, look at Figure 2 at left. Figure 2 is the same as Figure 1, except that \$70 is marked as the world price, and points A and B have been highlighted.

Point A states that at \$70, U.S. consumers want only 60 bears. That’s the domestic quantity demanded after U.S. consumers, considering how much income they have to spend and how much they want the bears, decide how many bears are worth the expense. (Suppose – just for simplicity – that each person wants at most one bear.) The 61st potential bear buyer thinks the bear is worth just under \$70 and won’t buy it.

Point B states that at \$70, U.S. producers are able to produce 105 bears. That’s the domestic quantity supplied after U.S. producers, looking at their costs of production, decide how many bears they can profitably make. Only 105 bears can be made at a cost under \$70; only that many are worth making. Suppose – just for simplicity – that each company can make at most one bear. Then the 106th company is one that must spend just over \$70 to manufacture the bear, and won’t do it.

In this situation, the world price will remain at \$70, and U.S. firms will export bears. This can be found as the horizontal distance AB, projected down to the horizontal axis: BA = 105 – 60 = 45 bears.

But of course, trade riots rarely start because of exports. People tend to get more upset about imports.

Importing Teddy
What if teddy bears sell on the world market not for \$70, but for \$40? This situation is shown in Figure 3 at right, where points F and G indicate what happens.

Point F indicates that if the world price is only \$40, U.S. firms can afford to make only 45 teddy bears. Firms along the supply curve to the left of F can produce a bear for under \$40 and still be profitable, but firms to the right of F can’t: their costs are too high.

Point G shows that at a price of \$40, U.S. consumers are willing and able to buy 90 bears. The 91st customer thinks a teddy bear is not quite worth \$40, so won’t buy it. But consumers along the demand curve to the left of G all think the bear is worth at least \$40 (in fact the demand curve tells us that the consumer of the 1st bear – on the leftmost point on the demand curve – would have been willing and able to pay \$130 for it!).

Ifn this situation, again it’s important to remember that where the supply and demand curves intersect is not relevant to the analysis. What is relevant is that at a price of \$40, U.S. firms will supply 45 bears, and U.S. consumers will want 90 bears, so 45 bears (the distance FG) will be imported: GF = 90 – 45 = 45 bears.

Who Gains and Who Loses When the World Price Falls
What if the price of teddy bears hadn’t always been \$40? Suppose we had started the year in the situation pictured in Figure 1: the price was \$55. Then something happened internationally – world demand for bears fell, or foreign production became cheaper – and the price fell to \$40. We would show this on our graphs by switching to Figure 3. That is, we lower the bar indicating the world price. (We wouldn’t show a shift in supply or demand, because that happened on the world market, and we’re just picturing the U.S. market.) But we’d have to ask: Who is hurt by this? Who benefits?

The people hurt, at least in the short run, are in two groups, both on the supply curve.

1. The first hurt is all those firms – and their workers and owners – who were producing teddy bears at \$55 but can’t afford to produce them at \$40. These firms are on the supply curve above point F but below the supply-and-demand intersection point. These firms were knocked out of the market. Presumably, they’re going to enter another market, but at least in the short run they’ll be unemployed, and the “short” run can be long and usually is painful. (These resources’ inability to produce for \$40 indicates that they are valued elsewhere. Remember this from comparative advantage: if you’re high-cost at producing one thing, you must therefore be low-cost at producing something else.)

2. The second group hurt is those on the supply curve to the left of point F. Sure, they’re still in the teddy bear market; they’re not bankrupt; they’re still employed. But they used to be getting \$55 per bear, and now they’re getting \$40. Their profits are lower.

The people who benefit, and benefit into the long run, can be found on the demand curve. Again, we have two groups.

1. The first and most obvious group is the demanders to the right of the supply-and-demand intersection point but to the left of G. They didn’t used to be able to afford teddy bears, and now they can because the price is lower. Due to lower prices, U.S. consumers get 15 more bears than they used to. At \$55, quantity was 75, all produced domestically; now at \$40, it’s 90, with 45 imported. Picture 15 happy smiling children on the demand curve in this space, happily hugging teddies.

2. The second group is the demanders located on the demand curve above and to the left of the supply-and-demand intersection point. These are the people who are willing and able to pay \$55 or more for a bear, and were buying them at the old world price. Now they have to pay only \$40 for the same bear. Each of these people is \$15 richer. They used to go to the store with \$55 and come home with a bear; now they come home with a bear and \$15 change. Picture 75 happy smiling parents on the demand curve in this space, happily hugging their money.

A microeconomic analysis would prove that when prices fall in this way the consumers/gainers gain more than the producers/losers lose (if you’ve had micro, compare the consumer surplus gained with the producer surplus lost; if you haven’t had micro, trust me). But in the real world the consumers are widespread, and the gains per person are small, while the producers are more concentrated, and the losses per firm are large. If foreign teddy bears flood the market and push prices down from \$55 to \$40, you may get a cheaper teddy bear, but a whole firm risks closure. Will you write your congressman to protect your \$15? Not likely. Will the firm send a lobbyist to Washington to talk about dangerous foreign bears and the need for teddy bear protection? Oh yes.

! Now you're ready to try Question #2 on the Tariffs & Quota exercise.

Teddy Bear Protection

• First Try: A Teddy Tariff

• Suppose the lobbyists are successful and get a tariff placed on the imported bears. A tariff is a tax a teddy bear producer must pay if and only if it is a foreign firm. Domestic teddy bear producers don’t pay the tax. Suppose the industry succeeds in getting a \$10 tariff placed on each imported bear. Then we have the situation below at left. The price is pushed up to \$50; domestic quantity supplied rises to 65, while domestic quantity demanded falls to 80 and imports fall to JK = KJ = 80 – 65 = 15.

We need to ask the same questions as above: who is helped, and who is hurt by the tariff? (This is a social science, remember!)

The people who are hurt by the tariff fall into two groups, both on the demand curve.

1. The demanders from K to G are no longer willing or able to buy teddy bears. They can afford \$40; they can’t afford \$50. Picture 10 crying children with no teddy bears.

2. The demanders to the left and above point K are also hurt. Their kids aren’t crying, but they are: each of their wallets is \$10 lighter. They were always willing and able to pay above \$50, but used to be able to get the bear for \$40 anyway. Now they can’t; now they’re poorer.
And now, who benefits from the tariff? This time we have three groups:

1. The most obvious beneficiaries are the firms along the supply curve from F to J. These firms are now able to compete on the world market. They couldn’t compete with foreign firms before, but now that foreign firms’ costs have been artificially raised by \$10, they can. For example, the firm just to the right of point F spends just over \$40 to produce a bear (that’s why that firm is on that point of the supply curve). That firm couldn’t compete before, because foreign firms could manufacture for, say, \$39.95. But now the same foreign firm that had a production cost of \$39.95 has a cost of \$49.95, \$10 of which is the tariff. The domestic firm just to the right of F can compete now. Even the firm just to the left of J, which has a true production cost of \$49.95, can compete. All these firms, and their workers, are happy.

2. However, the firms on the supply curve to the left of point F are happy too. They were in the market anyway because they can produce bears for less than \$40. They can truly meet foreign competition. But now that foreign competition is handicapped and prices have been pushed up to \$50 per bear, these firms can charge that, getting \$10 more profit on each bear. A freebie!

3. And finally, we have the government, which might explain why governments are usually sympathetic to tariffs. They get, after all, \$10 on each imported bear: \$10 x (80 – 65) = \$10 x 15 = \$150. This is the shaded area in the graph above. And the government can impose this tax while claiming it’s on foreigners. But it’s not. The people paying this tax are impoverished parents and crying children; the foreign firms have passed the burden of the tax along to them in the form of higher prices.

So there were winners and losers. But on balance . . . ? Well (trust me, or do the micro yourself), what the gainers from protection gain (extra producer surplus or profit and tax revenue) is less than what the consumers lost (consumer surplus). So why would we pursue a policy where on balance we lose more than we gain? Because the losses from tariffs are spread wide and fairly thin over large numbers of consumers, and the gains from tariffs are spread narrowly and fairly thickly over small numbers of firms. The tariff on an imported car, for example, even though it might mean an extra \$1000 to you as the consumer – or might mean you can’t afford a car at all – means extra billions to the domestic car manufacturer. And note that the industry could shut out imports altogether by making the tariff sufficiently high: \$15 per bear would do it.

! Now you're ready to try Question #3 on the Tariffs & Quota exercise.

• Second Try: A Teddy Quota

• Maybe a quota would be a better idea. A quota is a physical restriction on the amount of imports. Graphically, it works a little differently. In the tariff situation, we started at the world price and lifted the price bar up by the amount of the tariff to find the new price. In a quota situation, we don’t go “from the bottom up”; we go “from the top down.” Suppose the industry pushed for a 30-teddy quota. The situation looks like Figure 5 below. To show a 30-teddy quota, start at the intersection point of supply and demand. There, imports are 0. Going down from that point, continue until the horizontal distance between supply and demand (the amount of imports) is 30. Mark that line. At right, that’s the line LM. (Projecting it down onto the horizontal axis, we can see that it’s 85 – 55 = 30 teddy bears, as required.) Then look right to see what kind of price that will cause. We see that, relative to free trade (Figure 3), price and domestic quantity supplied has risen, while imports and domestic quantity demanded has fallen. So again we ask: Who is hurt? Who benefits?

Who is hurt by the quota? Once again, it’s consumers: two groups.

1. The crying children are located along the demand curve from M to G. These 5 children no longer have teddy bears.

2. The crying parents are located along the demand curve above and to the left of M. They are each \$5 poorer.

Who benefits from the quota? As with the tariff, three groups. Two are the same, and one . . . .

1. As with the tariff, there is a group of firms, from F to L in Figure 5, that are now able to compete because the artificial, quota-created, shortage of teddy bears has pushed up the price to \$40. So now, even though teddy bears can really be produced for \$40 everywhere else in the world, U.S. producers who use even \$44.99 of resources to make a bear can turn a profit by entering the market. They’re happy.

2. And again, as with the tariff, the U.S. firms who are productive enough to compete internationally now get the gift of \$5 extra per bear. The producer just to the left of F, who was in the market anyway because he can produce a bear for \$39.99, can now sell it for \$45 instead of \$40.

3. Now for our third group. This time it’s not the government; no tax is collected. So who benefits? The new beneficiaries are whichever foreign firms manage to get bears into the U.S. Teddies sell everywhere else in the world for \$40, but since they sell here for \$45, foreign producers who sell here get an extra \$5 per bear: \$5 x (85 – 55) = \$5 x 30 = \$150. This helps explain why foreign firms don’t get as upset about quotas as they do about tariffs: they get a piece of the action.

And again (trust me, or do the micro yourself), what the gainers from protection gain (extra producer surplus or profit to foreign and domestic firms) is less than what the consumers lost (consumer surplus). So why would we pursue a policy where on balance we lose more than we gain? Because the losses are spread wide and fairly thin over large numbers of consumers, and the gains are spread narrowly and fairly thickly over small numbers of firms. (Is this sounding familiar?) The quotas on imported sugar, for example, might mean an extra \$20 to you annually as the consumer – or might mean you can’t afford as much cereal – but it means extra billions to the (very few) domestic sugar producers.

Got it? Almost? Congratulations! Now you can finish the Tariffs & Quota exercise.