Import Quotas with Perfect Competition:

Figure demonstrates  the effect of  an  import quota when markets are perfectly  competitive. D  and  S represent the demand and  supply curves for the  good before quota imposition. Under free trade,  the world  price  Pw  prevails a nd  total domestic production  is Q₁  ,  demand is Q₂, and Q₁Q₂ amount is imported.

Now  suppose an import  quota  is imposed, which  restricts  imports  to Q₁Q₃ (where, Q₁Q₃< Q₁Q₂).  Im- mediately with quota imposition, at the world price Pw, domestic demand falls short of total domestic production plus imports. This excess domestic demand drives up prices in the domestic market, till the market clears.

The quota effectively shifts the domestic supply curve to S', by  the amount of the quota. The economy moves to the new  equilibrium E', where price has risen from Pw  to P', domestic production has increased from Q₁ to Q₄  while domestic demand has fallen from Q₂ to Q₅.  At E',  imports, restricted by the quota, are equal to the amount Q₄Q₅  (note that Q₁Q₂ = Q₅Q₄  = import quota).

A tariff rate equal to P'-  P_w,  is the tariff equivalent of the quota. It would have restricted imports to the same level as the quota and had the same effect on domestic prices. However,  it may not always be feasible to implement the tar- iff equivalent of a quota, as the rate may be too high to be acceptable. You  should see that as in case of a tariff, a quota involves a loss in consumer surplus equal to the area (a + b  + c + d). This is offset by a rise in producer surplus equal to  the area a. But  an important difference between tariffs and quotas arises from the  fact that with a quota  the government does not  earn revenues  as  in  case of a  tariff. The area c therefore does not  accrue to  the government, rather it represents the quota rent, which may be captured by the import-license holders, who buy at the world price Pw  and sell at a higher price P', making a profit of (P' -  P_w)  per unit of imports. If c accrues to the license holders and is counted as part of social gain, then the social loss from  the quota is equal to the area (b+ d),  same as in case of a tariff.

Often foreign exporters have the right to sell directly in  the domestic market. In that case  the quota  rent c would accrue  to foreigners and it would be a social loss from the domestic country's point of view.

Another disturbing possibility, and one that  is often observed  in practice, is that the quota rent  may  not accrue  to  license holders. Rather it may be dissipated  in  rent-seeking activities, like paying bribes  to acquire import licenses and so on. In that case, the area c would be a social loss and the total cost imposed by the quota would equal the area (b+c+d), which is more than in case of an  equivalent  tariff.  In fact quota rents have been estimated to be as high as  24% of GNP in developing countries like Kenya. Governments  in  developing countries have the option  to  auction import licenses. A  competitive bidding process would drive  the price of licenses up to (P' -  P_w)  per unit of imports and the government would earn revenue equal to the area c. If this process worked smoothly, the effects of a tariff and quota would be equivalent. However, developing country experiences demonstrate that  in reality the auction process may also run  into difficulties. The auctions may not be competitive and  collusion among bidders might subvert the entire process.