Question

Draw a graph of the U.S. automobile market in which the domestic equilibrium price without trade is \(P_{\mathrm{d}}\) and the equilibrium quantity is \(Q_{\mathrm{d}}\). Use this graph to illustrate and explain the effects of a tariff if the United States were an auto importer with free trade. Then use the graph to illustrate and explain the effects of a quota.

Short answer

Answer: Both a tariff and a quota encourage domestic production and reduce imports in the U.S. automobile market. The main difference between the two policies is that the tariff generates government revenue, while the quota does not. The tariff increases the price of imported automobiles, leading to an expansion of domestic production and a contraction of domestic consumption. On the other hand, the quota limits the quantity of imported automobiles, leading to an expansion of domestic production and a contraction of domestic consumption.

Step-by-step solution

Draw the supply and demand curves for the U.S. automobile market

To begin, draw a graph with two axes: on the horizontal (x) axis, you must represent the quantity of automobiles (Q), and on the vertical (y) axis, you should represent the price of automobiles (P). Now, draw two curves representing supply (S) and demand (D).

Identify the domestic equilibrium price and quantity

Identify the intersection point of the supply and demand curves. This point represents the domestic equilibrium price (\(P_{\mathrm{d}}\)) and quantity (\(Q_{\mathrm{d}}\)) of automobiles.

Illustrate the effects of a tariff

Now, assume that with free trade, the world price of automobiles is lower than the domestic equilibrium price (\(P_{\mathrm{w}} < P_{\mathrm{d}}\)). In this case, the U.S. will import automobiles. To illustrate the effects of a tariff on imported automobiles, add a horizontal line at the level of the world price plus the tariff (\(P_{\mathrm{w}} + T\)). Then, find the new equilibrium points for supply (at \(Q_{S1}\)) and demand (at \(Q_{D1}\)) with the tariff included. As a result of the tariff, the price of imported automobiles increases, domestic production expands, and domestic consumption contracts. The difference between \(Q_{S1}\) and \(Q_{D1}\) represents the quantity of imported cars with the tariff. Note that government revenue is generated through the tariff, represented by the area of a rectangle with width \((Q_{D1} - Q_{S1})\) and height \(T\).

Illustrate the effects of a quota

To illustrate the effects of a quota, remove the tariff from the graph, and reintroduce the horizontal line representing the world price (\(P_{\mathrm{w}}\)). Next, assume that the quota on imported cars allows only a certain quantity (Q*) to be imported. To illustrate this, add vertical lines representing the supply curve with a quota (\(S_{Quota}\)) at \(Q_{\mathrm{d}}+Q^*\) and the original domestic supply (\(S\)). As a result of the quota, the domestic production expands to \(Q_{\mathrm{d}}\), the difference between the original supply and the new supply curve with the quota. The domestic consumption contracts to \(Q_{\mathrm{d}} + Q^*\), and imports are limited to the amount specified by the quota (Q*). In conclusion, both the tariff and the quota encourage domestic production and reduce imports in the U.S. automobile market. The main difference between the two policies is that the tariff generates government revenue, while the quota does not.

Key concepts

Tariff Effects on Imports

When discussing the tariff effects on imports, we delve into the government's utilization of tariffs as a tool to control the balance of trade. A tariff, essentially, is a tax imposed on imported goods. Its immediate impact is an increase in the cost of foreign products, which shifts the market dynamics.

Taking the U.S. automobile market as an example, the imposition of a tariff would raise the world price from its initial level (\(P_{\rm w}\)) to a new level that includes the tariff (\(P_{\rm w} + T\)). In simple terms, the addition of a tariff to the cost of imported automobiles makes them more expensive.

As a result, the demand for imports declines, and consumers may seek alternatives within the domestic market, leading to an expansion in the production of local automobile manufacturers. This is evident from the shift in equilibrium quantity demanded (\(Q_{D1}\)) and supplied (\(Q_{S1}\)) in the presence of the tariff. Moreover, it's important to highlight that tariffs also generate revenue for the government. This is denoted in economic graphs by the area between the import demand and supply at the new world price inclusive of the tariff.

Quota Impact on Trade

Moving to the notion of a quota impact on trade, a quota is a restriction on the quantity of goods that can be imported. Unlike tariffs, quotas do not generate revenue for the government but instead create a limitation on the supply side.

In the U.S. automobile example, if the government sets a quota on the number of cars that can be imported, this essentially caps the number at (\( Q^* \)). This restricts the total quantity to the sum of domestically produced automobiles (\(Q_{\rm d}\)) and the quota-imposed number of imported cars. The domestic suppliers may increase production up to the quota limit, following which no more imports will be allowed.

Implementing a quota generally drives up the price of the limited available foreign automobiles due to the now-scarcer supply. It might also lead to additional market distortions, such as the creation of trade in import licenses or a shift in profits from domestic consumers to foreign suppliers. While quotas expand domestic production similarly to tariffs, they can have different and sometimes more complex outcomes on the market.

Supply and Demand Curve Analysis

The supply and demand curve analysis lies at the heart of understanding market equilibrium. It's a fundamental tool economists use to visualize the relationship between the price of goods and the quantity supplied and demanded.

Using the U.S. automobile market as an example, the intersection of the supply curve (\(S\)) with the demand curve (\(D\)) indicates the market equilibrium without any trade intervention. This shows the domestic equilibrium price (\(P_{\rm d}\)) and quantity (\(Q_{\rm d}\)).

When an external factor like a tariff or a quota is introduced, the original supply and demand curves shift to reflect the new market conditions. A tariff introduces a new price level that contains the tax, which in turn adjusts the equilibrium quantity of imports. On the other hand, a quota adds constraints to the supply side, which impacts the available quantity directly, as seen in the kinked supply curve.