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Suppose Mexico, the importing country in free trade, imposes a binding import quota on wheat. The quota will restrict the flow of wheat across the border. As a result, the supply of wheat to the Mexican market will fall, and if the price remains the same, it will cause excess demand for wheat in the market. The excess demand will induce an increase in the price of wheat. Since wheat is homogeneous and the market is perfectly competitive, the price of all wheat sold in Mexico, both Mexican wheat and U.S. imports, will rise in price. The higher price will, in turn, reduce demand and increase domestic supply, causing a reduction in Mexico’s import demand.
The restricted wheat supply to Mexico will shift supply back to the U.S. market. Since Mexico is assumed to be a large importer, the supply shifted back to the U.S. market will generate excess supply in the U.S. market at the original price and cause a reduction in the U.S. price. The lower price will, in turn, reduce U.S. supply, raise U.S. demand, and cause a reduction in U.S. export supply.
These price effects are identical in direction to the price effects of an import tax, a voluntary export restraint, and an export tax.
A new quota equilibrium will be reached when the following two conditions are satisfied:
where is the quantity at which the quota is set, is the price in Mexico after the quota, and is the price in the United States after the quota.
The first condition says that the price must change in Mexico such that import demand falls to the quota level . In order for this to occur, the price in Mexico rises. The second condition says that the price must change in the United States such that export supply falls to the quota level . In order for this to occur, the price in the United States falls.
The quota equilibrium is depicted on the graph in Figure 7.24 "Depicting a Quota Equilibrium: Large Country Case". The Mexican price of wheat rises from PFT to , which is sufficient to reduce its import demand from QFT to . The U.S. price of wheat falls from PFT to , which is sufficient to reduce its export supply from QFT to .
Figure 7.24 Depicting a Quota Equilibrium: Large Country Case
Notice that there is a unique set of prices that satisfies the equilibrium conditions for every potential quota that is set. If the quota were set lower than , the price wedge would rise, causing a further increase in the Mexican price and a further decrease in the U.S. price.
At the extreme, if the quota were set equal to zero, then the prices in each country would revert to their autarky levels. In this case, the quota would prohibit trade.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”