Types of Trade Restrictions

Governments may enact policies that limit the free exchange of goods and services between countries. Such policies are known as trade restrictions or trade protections and include tariffs, import quotas, voluntary export restraints (VER), subsidies, embargoes, domestic content requirements, and capital restrictions.

Trade restrictions are used to: Protect already established domestic industries from foreign competition, protect new domestic industries from foreign competition until they get established, protect and increase domestic employment, generate income from imposed tariffs, retaliate against the restrictions imposed by another country, and to protect certain industries/sectors for national security purposes.

Different trade restrictions are discussed below.

Tariffs

A tariff is a type of tax that imposes additional costs on imports. Tariffs primarily aim to protect the domestic industries that produce similar goods and to reduce trade deficits.

The economic impact of tariffs is reduced demand for imported goods as they will be trading at a price above the free trade price.

We need to define “small” and “large” countries in the context of tariffs. A small country is a price taker and cannot influence market prices, whereas a large country is a large importer of goods and can influence the world market price.

Tariffs imported by large countries will force exporters to reduce the price of goods/services to retain their market share in the importing country, thereby altering the terms of trade and redistributing income from the exporting to the importing country.

As such, theoretically, a large country can only increase its welfare through tariffs if its trading partner does not retaliate and if the benefits of improving the terms of trade are greater than the deadweight loss resulting from the tariff.

In summary, the net welfare effects of tariffs are:

• Loss of consumer surplus due to price increase.
• A gain in producer surplus as local producers can sell their output at higher prices.
• Gain of tariff revenue to the government.

Note: The loss in consumer surplus is greater than the gain from producer surplus and increased tariff revenue to the government, thereby resulting in a deadweight loss to a country’s welfare.

Import Quotas

Import quotas refer to the regulations set by a country that restrict the amount of a specific good that can be imported into the country, usually for a specified period. On the other hand, import licenses specify the quantity of goods that can be imported into a country.

As compared to tariffs where the government of the country imposing the tariff gains tariff revenue, the effect of quotas on the government is uncertain. Foreign producers can raise their prices after a country imposes a quota to gain higher profits than they would without the quota. These profits are known as quota rents.

The welfare loss to an importing country after imposing import quotas is greater than that under an equivalent tariff. However, the loss can be similar to that of an equivalent tariff if the government of the importing country can capture the quota rents by auctioning import licenses at a fee.

Voluntary Export Restraints (VER)

As opposed to an import quota that is created by the government of an importing country, a VER is created by the government of the exporting country to limit the number of goods it can export to its trading partner. A VER allows the quota rent resulting from the decrease in trade to be captured by the exporting country, resulting in a welfare loss to the importing country.

Export Subsidies

An export subsidy is when the government pays a firm for each unit it exports in a bid to stimulate exports.

Export subsidies disrupt the functioning of the free market and distort trade away from comparative advantage, thereby reducing welfare.

Importing Countries may impose countervailing duties, which are taxes levied by an importing country on subsidized goods entering the country.

Export subsidies may create an incentive for domestic producers to shift their sales from the domestic to the export market to benefit from higher prices (international price plus the export subsidy), increasing the price of the goods in the domestic markets by the amount of the subsidy for a small country.

For a large country, the world price will decline as the large country increases exports. As such, the net effect in both the large and small countries is negative, with large countries experiencing a higher decline.

Capital Restrictions

Capital restrictions refer to the measures a government or central bank takes to control the flow of capital. This could be capital flowing in and out of the economy. Controls include taxes, tariffs, volume restrictions, etc., whereas regulations include foreign exchange, tax regulation, credit regulation, and investment restrictions.

They have similar effects as trade restrictions – protect domestic industries – but capital restrictions can slow growth, and more restrictions can mean higher domestic prices for goods.

Controls are useful when they enable a government to deal with currency exchange rates and interest rates. The government benefits from tariffs since they are a type of revenue (tax).

Industries benefit from reduced competition since import prices are high. On the flip side, consumers do not benefit because the increase in import prices means higher prices. The most apparent difference between trade restrictions and capital restrictions is that trade restrictions limit access to a wide range of goods and services while capital restrictions limit access to financial markets.

Other Restrictions

• Domestic content provisions specify that some proportion of the value added or components used in production should be of domestic origin.
• Embargo is a government order that restricts trade or commerce with a specified country or the exchange of specific goods. Embargoes are typically enacted due to unfavorable political or economic circumstances between nations.

$$ \begin{align*} & \textbf{Summary of Effect of Trade Restrictions} \\ & \textbf{on Producer and Consumer Surpluses} \end{align*} \\
\begin{array}{l|l|l|l|l}
& \textbf{Tariff} & { \textbf{Import} \\ \textbf{Quota} } & {\textbf{Export} \\ \textbf{Subsidy}} & \textbf{VER} \\ \hline
\textbf{Impact on} & {\text{Importing} \\ \text{Country}} & {\text{Importing} \\ \text{Country}} & {\text{Exporting} \\ \text{Country}} & {\text{Importing} \\ \text{Country}} \\ \hline
{ \text{Producer} \\ \text{Surplus}} & \text{Increases} & \text{Increases} & \text{Increases} & \text{Increases} \\ \hline
{\text{Consumer} \\ \text{Surplus}} & \text{Decreases} & \text{Decreases} & \text{Decreases} & \text{Decreases} \\ \hline
\text{Price} & \text{Increases} & \text{Increases} & \text{Increases} & \text{Increases} \\ \hline
{\text{Domestic} \\ \text{Consumption}} & \text{Decreases} & \text{Decreases} & \text{Decreases} & \text{Decreases} \\ \hline
{\text{Domestic} \\ \text{Production}} & \text{Increases} & \text{Increases} & \text{Increases} & \text{Increases} \\ \hline
\text{Trade} & {\text{Imports} \\ \text{decrease}} & {\text{Imports} \\ \text{decrease}} & {\text{Exports} \\ \text{decrease}} & {\text{Imports} \\ \text{decrease}}
\end{array} $$

$$ \begin{align*} &\textbf{Summary of Effect of Trade Restrictions on} \\ &\textbf{Government Revenue and National Welfare.} \end{align*} \\
\begin{array}{l|l|l|l|l}
& \textbf{Tariff} & { \textbf{Import} \\ \textbf{Quota} } & {\textbf{Export} \\ \textbf{Subsidy}} & \textbf{VER} \\ \hline
{\text{Government} \\ \text{Revenue} } & \text{Increases} & {\text{Mixed} \\ \text{(depends on} \\ \text{whether quota} \\ \text{rents are} \\ \text{captured by} \\ \text{the importers} \\ \text{or exporters)} } & \text{Decreases} & \text{No change} \\ \hline
{\text{National} \\ \text{Welfare} } & {\text{Decreases in} \\ \text{small countries} \\ \text{and increases} \\ \text{in the larger} \\ \text{country.} } & { \text{Decreases in} \\ \text{small countries} \\ \text{and increases} \\ \text{in the larger} \\ \text{country.} } & \text{Decreases} & \text{Decreases} \end{array} $$

Question

Which of the following trade restrictions will most likely increase the revenue of the country imposing the restriction?

1. Tariffs.
2. Import Quotas.
3. Export subsidies.

Solution

The correct answer is A.

The government of the country imposing tariffs (taxes that impose additional revenue on imported goods) gains the tariff revenue.

B is incorrect. Import quotas will only benefit the government if it sells import licenses. Import quotas majorly benefit foreign producers as they sell their produce at a higher price to capture the quota rent.

C is incorrect. Export subsidies decrease revenue to the government as the government spends to pay firms for each unit they export.