Trade Restrictions, Agreements, and Their Economic Implications | CFA Level I Economics

In this lesson, we will explore various types of trade restrictions, their economic implications, and the reasons why some nations impose them. We will also briefly discuss trade agreements that help promote free trade.

Types of Trade Restrictions

Trade restrictions, or trade protection, are government policies that limit trade with other countries. They can be imposed by the government of countries that import or export goods. Trade restrictions include:

• Tariffs: Taxes collected by the government on imported goods.
• Quotas: Limits on the amount of imports allowed for each period.
• Voluntary Export Restraints: Limits on the amount of a good that can be exported, self-imposed by the exporting country.
• Export Subsidies: Payments made to producers for every unit exported, which violates free market principles and is considered a trade restriction.

Economic Implications of Trade Restrictions

Each of these four trade restrictions can affect both the importer and exporter differently. Let’s examine the economic implications, starting with the importer’s domestic market.

In a free market, there is always a demand and supply curve. Without imports, the market equilibrium output and price of the good will be at a specific point. However, if imports are allowed without restrictions, the market price will take the world price for the good. Since domestic producers cannot produce enough to meet demand at this price point, the remaining quantity is imported.

With a tariff on the good, the tariff is most likely passed on to the consumers, so the market price should rise by the tariff amount. At this price, domestic producers want to supply more, so domestic output increases. The demand by consumers is lower, so the amount of imports is reduced.

Let’s consider a hypothetical scenario:

• Without trade restrictions, the domestic price of a good is $5, and the world price is $3.
• The government imposes a $1 tariff on the imported good.
• The market price rises to $4 ($3 + $1).
• Domestic producers supply more, and imports decrease.

You would have noticed that the biggest casualty of a tariff is the consumer, as the amount of consumer surplus is greatly reduced. The domestic producers gain as they sell more at a higher price, so the producer surplus is increased. The government takes a portion, which is the amount of tariffs collected. This increases government revenue. However, there are two empty portions, which are the deadweight loss. This implies that national welfare is reduced.

A quota has the same effect as a tariff. When the amount of imports is limited to a level lower than the domestic demand, the domestic price increases above the world price. This has the exact same effect as tariffs in lowering consumer surplus, increasing producer surplus, and reducing national welfare.

Voluntary export restraints are very similar to a quota, except that this limit is self-imposed by the exporting country’s government. In a way, this can be seen as the exporting country’s attempt to capture the quota rent, rather than to let the importing country have it.

Lastly, export subsidies affect the exporting country more than the importing country. By subsidising the producers for exporting, the producers can produce more to export, so the domestic price increases by the subsidy amount. The producer surplus is increased, at the expense of consumer surplus. This is also at the expense of taxpayers, as government revenue is spent on the subsidies.

Reasons for Imposing Trade Restrictions

Given the problems and disadvantages of imposing trade restrictions, why do governments still do it? There could be many reasons, but some of the most common justifications include:

• Protecting domestic industries from foreign competition.
• Protecting new industries from foreign competition until they mature (infant industry argument).
• Protecting and increasing domestic employment.
• Protecting strategic industries for national security reasons.
• For developing countries, tariffs can be significant sources of government revenue.
• Retaliation against trade restrictions imposed by other countries.

Trade Agreements and Trading Blocs

To break down trade restrictions, countries negotiate with each other various forms of trade agreements such that all involved countries can benefit from free trade. These types of agreements, generally referred to as trading blocs or regional trading agreements, are listed in order of their degrees of integration:

1. Free Trade Area: No barriers to import and export of goods and services among member countries. One example is the North American Free Trade Agreement.
2. Customs Union: A free trade area plus the requirement that all countries adopt a common set of trade restrictions with non-members.
3. Common Market: A customs union plus free movement of labor and capital goods among member countries. The Southern Cone Common Market of Argentina, Brazil, Paraguay, and Uruguay is an example of a common market.
4. Economic Union: A common market plus the requirement of common institutions and economic policy for the union. The European Union is one such example.
5. Monetary Union: The most integrated bloc, which also requires member countries to adopt a single currency. The Eurozone is a monetary union, where the common currency is the Euro.

While the removal of trade restrictions can, in most cases, improve economic welfare within the member nations, such welfare gains can be reduced if restrictions on trade with non-member countries shut off cheaper sources of imports for the country.