This is “Voluntary Export Restraints (VERs): Large Country Price Effects”, section 7.19 from the book Policy and Theory of International Trade (v. 1.0). For details on it (including licensing), click here.
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Suppose the United States, an exporting country in free trade, imposes a binding export quota, often called a voluntary export restraint (VER) when implemented bilaterally, on wheat exports to Mexico. The VER will restrict the flow of wheat across the border. Since the United States is a large exporter, the supply of wheat to the Mexican market will fall, and if the price remained the same it would 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, causing excess supply in the U.S. market at the original price and 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 and an import quota by the importer country, and an export tax by the exporting country.
A new VER equilibrium will be reached when the following two conditions are satisfied:
where is the quantity at which the VER is set, is the price in Mexico after the VER, and is the price in the United States after the VER.
The first condition says that the price must change in Mexico such that import demand falls to the VER 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 VER level . In order for this to occur, the price in the United States falls.
The VER equilibrium is depicted graphically in Figure 7.35 "Depicting a VER 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 also from QFT to .
Figure 7.35 Depicting a VER Equilibrium: Large Country Case
Notice that a unique set of prices satisfies the equilibrium conditions for every potential VER that is set. If the VER 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 VER were set equal to zero, then the prices in each country would revert to their autarky levels. In this case, the VER would prohibit trade. This situation is similar to an export embargo.
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?”