Understanding Quotas
A quota limits trade by restricting the number of goods that can legally be imported into a country. In the graph below, we can analyze the market outcomes of Autarky (no trade), Free Trade, and Quota restricted trade.
Suppose that the autarky price of clothing in this economy is P1, and that the free trade (world) price of clothing is P3. We can measure the wealth that trade creates by measuring the consumer and producer surplus created by trade.
In autarky, the quantity produced and consumed domestically is Q3. Consumer and producer surplus are summarized in the table below. Opening the country to free trade reduces domestic production from Q3 to Q1 simultaneously reducing producer surplus and increasing consumer surplus. You can clearly see why developed nations wanted to protect their clothing industries. Such a large reduction in domestic production would have injured domestic producers. Recall, however, that the consumers are made better off by trade by more than the injury to producers. So, in the 1960's the government chose a middle road - quotas - that would permit some trade and provide some protection to domestic industry. It's important to note, however, that this "middle road" meant that some people - producers - were enriched at the expense of other people - consumers - and that the society as a whole was poorer than it otherwise would have been.
Setting a quota on imports equal to Q4-Q2 would result in a domestic price of P2 with domestic production of Q2 and domestic consumption of Q4 with imports of Q4-Q2 - the size of the quota. Notice how producer surplus rises from the free trade position at the expense of consumers.
The change in consumer surplus comes from three sources. First, the increased producer surplus E, the deadweight loss of FI, and finally the quota rents of GH.
The deadweight loss is the amount of wealth that is destroyed by the restriction of trade (some trades don't occur, so some wealth doesn't get created).
The quota rents are the economic profits earned by the holder of the quota. Essentially, the quota rent is a pure wealth transfer from the domestic consumers to the foreign producers (holder of the quota). In this light, you can see why foreign producers grew quickly under the quota system - it essentially guaranteed profits.
| Summary of Welfare Effects | |||
|---|---|---|---|
| Autarky | Free Trade | Quota Trade | |
| Consumer Surplus | A | ABCDEFGHI | ABCD |
| Producer Surplus | BEJ | J | EJ |
| Quota Rents | GH | ||
| Dead Weight Loss | FI | ||
| Total Gains | ABEJ | ABCDEFGHIJ | ABCDEGHJ |
| Difference from Autarky | CDFGHI | CDGH | |
| Difference from Free Trade | FI | ||