Ever since David Ricardo laid out the principle of comparative advantage in the early nineteenth century most economists have advocated free trade. That is, they have argued that government policy should not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand.

Despite the free-trade arguments of economists, however, many governments use taxes and other restrictions to limit imports. Less frequently, governments offer subsidies to encourage exports. Policies that limit imports, usually with the goal of protecting domestic producers in import-competing industries from foreign competition, are known as trade protection or simply as protection.

Let’s look at the two most common protectionist policies, tariffs and import quotas, then turn to the reasons governments follow these policies.

A tariff is a form of excise tax, one that is levied only on sales of imported goods. For example, the U.S. government could declare that anyone bringing in phones must pay a tariff of $100 per unit. In the distant past, tariffs were an important source of government revenue because they were relatively easy to collect. But in the modern world, tariffs are usually intended to discourage imports and protect import-competing domestic producers rather than as a source of government revenue.

The tariff raises both the price received by domestic producers and the price paid by domestic consumers. Suppose, for example, that our country imports phones, and a phone costs $200 on the world market. As we saw earlier, under free trade the domestic price would also be $200. But if a tariff of $100 per unit is imposed, the domestic price will rise to $300, because it won’t be profitable to import phones unless the price in the domestic market is high enough to compensate importers for the cost of paying the tariff.

Figure 8-10 illustrates the effects of a tariff on imports of phones. As before, we assume that P_W is the world price of a phone. Before the tariff is imposed, imports have driven the domestic price down to P_W, so that pre-tariff domestic production is Q_S, pre-tariff domestic consumption is Q_D, and pre-tariff imports are Q_D – Q_S.

Now suppose that the government imposes a tariff on each phone imported. As a consequence, it is no longer profitable to import phones unless the domestic price received by the importer is greater than or equal to the world price plus the tariff. So the domestic price rises to P_T, which is equal to the world price, P_W, plus the tariff. Domestic production rises to Q_ST, domestic consumption falls to Q_DT, and imports fall to Q_DT – Q_ST.

A tariff, then, raises domestic prices, leading to increased domestic production and reduced domestic consumption compared to the situation under free trade. Figure 8-11 shows the effects on surplus. There are three effects:

The welfare effects of a tariff are summarized in the table in Figure 8-11. Producers gain, consumers lose, and the government gains. But consumer losses are greater than the sum of producer and government gains, leading to a net reduction in total surplus equal to areas B + D.

An excise tax creates inefficiency, or deadweight loss, because it prevents mutually beneficial trades from occurring. The same is true of a tariff, where the deadweight loss imposed on society is equal to the loss in total surplus represented by areas B + D.

Tariffs generate deadweight losses because they create inefficiencies in two ways:

An import quota, another form of trade protection, is a legal limit on the quantity of a good that can be imported. For example, a U.S. import quota on Chinese phones might limit the quantity imported each year to 50 million units. Import quotas are usually administered through licenses: a number of licenses are issued, each giving the license-holder the right to import a limited quantity of the good each year.

A quota on sales has the same effect as an excise tax, with one difference: the money that would otherwise have accrued to the government as tax revenue under an excise tax becomes license-holders’ revenue under a quota—also known as quota rents. (Quota rent was defined in Chapter 5.) Similarly, an import quota has the same effect as a tariff, with one difference: the money that would otherwise have been government revenue becomes quota rents to license-holders. Look again at Figure 8-11. An import quota that limits imports to Q_DT – Q_ST will raise the domestic price of phones by the same amount as the tariff we considered previously. That is, it will raise the domestic price from P_W to P_T. However, area C will now represent quota rents rather than government revenue.

Who receives import licenses and so collects the quota rents? In the case of U.S. import protection, the answer may surprise you: the most important import licenses—mainly for clothing, and to a lesser extent for sugar—are granted to foreign governments.

Because the quota rents for most U.S. import quotas go to foreigners, the cost to the nation of such quotas is larger than that of a comparable tariff (a tariff that leads to the same level of imports). In Figure 8-11 the net loss to the United States from such an import quota would be equal to areas B + C + D, the difference between consumer losses and producer gains.