A.

Hidhayathulla, Associate Professor of

Economics,
Unit II
 Lesson 1
Meaning of Terms of Trade
 :
Physical exchange ratio at which goods are exchange for one
another between the countries.
Index of export prices(PX) x 1oo
Terms of trade(T) = Index of import prices(Pm)
(T=Terms of trade; PX= Index of export prices; Pm=Index of import
prices.) This is also called the index of trade.
Terms of trade are used to measure the gain or loss from international
trade. Terms of trade can be favourable or unfavourable to a nation.
1) Favourable Terms of Trade: Terms of the trade become favourable
for a country if this index increase. Export prices increase by 15%
and import prices increase by 5%, then the index of terms of trade
increase from 100 to 109.

2) Unfavourable Terms of Trade: Terms of trade becomes

unfavourable when percentage change in export prices is less than the
percentage change in import prices. Then the terms of trade index
should be:
Terms of trade (TOT)=105/110 x 100=95(approx.)
 Lesson 2 - Concepts of Terms of Trade
Concepts classified by Jacob Viner and Meier
1) Net Barter or commodity Terms of trade
2) Gross Barter Terms of trade
3) Income Terms of trade
4) Single Factoral Terms of trade
5) Double Factoral terms of trade
6) Real costs terms of trade
7) Utility terms of trade
 • (1) Net Barter or Commodity Terms of Trade :
Commodity terms of trade in a formula form:
TC=PX/Pm
(here, TC= commodity terms of trade; PX= Index of export prices; Pm= Index of import
prices.)
Commodity terms of trade in different time period can be measured using formula:
Px1/Pm1 : Pxo/Pmo
(here, Px1= index of export prices in the current year, Pm1=Index of import price in the
current year; Pxo=Index of export price in the base; Pmo=Index of import prices in the
base year.)
Criticism:
i. The principle of commodity terms of trade is based on export and import prices
indices. It does not take into consideration the changes in composition of the
foreign trade and quality of the goods.
ii. The concept examines short-terms changes only. It throws no light on long-term
changes.
 • (2) Gross Barter terms of trade :
Formula
TQ= Qm/Qx
(TQ= Gross barter terms of trade; Qm=Quantity of imports; QX= Quantity of exports.)
Gross barter or commodity terms of trade in different time periods can be measured
as follows:
Qm1/QX1 : Qmo/Qxo
( Qm1= Index of quantity imported in the current year; Qx1=Index of quantity exported
in the current year; Qmo=Index of quantity imported in the base year; Qxo= Index of
quantity exported in the base year.)
Criticism:
i. According to Taussig, gross commodity terms of trade include unilateral
transactions, like donation, gifts, etc., in balance of payments, but it is not proper
because it does not represent the natural flow of trade.
ii. Gross commodity terms of trade do not provide any clue of payment of capital
and its effect.
iii. Like net commodity terms of trade, gross commodity terms of trade also do not
attach any importance to changes in the quality of goods.
 (3) Income terms of trade :
The income terms of trade is the ratio of index of the prices of exports and
index of prices of imports.
Ty= TcQx=PxQx/Pm (Tc=Px/Pm)
(here, Ty=Income terms of trade; Tc= Commodity terms of trade; Px= Index of prices of
exports;Qx=index of quantity exported ; Pm=Index of prices imports.)
Income terms of trade are also called capacity to import. It is so because, in the long-
run, the value of total export of a country is equal to the value of its total imports.
PxQx= PmQm (PxQx/Pm =Qm) [Qm= quantity of imports]
Criticism : Concept of income terms of trade does not throw any light on the
profits and losses of international trade.
i. Concept of income terms of trade is a narrow concept. Index of income terms of
trade relates to the capacity of imports as being dependent only on exports.
(4) Single factoral terms of trade:
Factoral terms of trade depend upon the productive efficiency of the factors
of production. The single Factoral terms of trade, commodity terms of trade are
multiplied by the index of export productivity.
Ts= Tc x Fx= Px/Pm x Fx ( Tc= Px/Pm)
Criticism : The greatest shortcoming of single factoral terms of trade is that it
does not take into consideration potential domestic cost of production of input
industries of importing country.
(5) Two Factoral Terms of trade :
Double factoral terms of trade takes into account the productivity of the
factors of production in the country’s exports as well as the productivity of the
foreign factors of production used in country’s imports.
Td= Tc x Fx/Fm = Px/Pm x Fx/Fm ( Td= Px/Pm)
(here, Td=Double factoral terms of trade; Tc= commodity terms of trade; Px= Index of
prices of exports; Fx=Index of productivity of export goods industries; Pm=Index of
prices of imports; Fm= Index of productivity of import goods industries.)
Criticism:
i. It is very difficult to estimate the index of double factoral terms of trade of a
country, because to do so it is necessary to measure the productivity of import
goods produced in the country.
ii. It is not possible to measure gains of international trade by this concept, because
no importance is given to the utility of the goods exported and imported.
 (6)Real Cost terms of trade
Import and export goods are compared according to their utility . Real cost of both
import and export is worked out. Real cost terms of trade is calculated by multiplying
the single factoral terms of trade with the index of the amount of disutility per unit of
productive resource used in producing exports.
TR= Ts x Rx = PX/Pm x Fxx Rx
(here,TR= Real cost terms of trade; Ts= Single factoral terms of trade; Px=Index of export
prices;Pm=Index of import prices; Fx=Index of productivity of export goods industries;
Rx= sacrifice of utility inherent in export.)
Criticism: Main defect of real cost terms of trade is that it is concerned only with the
quantity of foreign goods obtained with the real costs inherent in exports.
(7) Utility terms of trade
Utility terms of trade is the index of relative utility of import and domestic
commodities foregone to produce exports.
Tu= TR x U = Px/Pm x Fx x Rx x U
(here, Tu=Utility terms of trade; TR=Real cost terms of trade; PX=Index of export prices;
Pm=Index of import prices; Fx=Export productivity; Rx= Utility foregone to exports.)
Criticism : It is an unrealistic concept. Utility and disutility cannot be measured
precisely. Both concepts are subjective. This concept has no practical significance
 Lesson 3 - Factor influencing Terms of trade
1. Reciprocal Demand:
(i) Elasticity of Demand: Effects of elasticities of demand for
export goods on terms of trade differ from that of import goods. (a)
Elasticity of Demand of Exportable Goods: The demand of exports
of a country is less elastic then terms of trade will be in its
favour.(b) Elasticity of demand of Importable Goods: Terms of
trade will be favourable to a country whose demand for imports is
more elastic. On the other hand, if the demand for imports is less
elastic, terms of trade will be unfavourable.
(ii) Elasticity of supply: Effects of elasticities of supply of export
goods on terms of trade differ from that of import goods. (a) If the
supply of export is less elastic then terms of trade will be
unfavourable and if more elastic the same will be favourable.(b)If
Supply of imports is less elastic, then terms of trade will be
favourable and if supply of import is more elastic, terms of trade
will be unfavourable.
• 2. Size of Demand: With the increase in demand for the
exports of a country, prices of export will increase as against
the prices of imports and hence, terms of trade become
favourable. If demand for imports increase, their prices will
also increase as against the prices of export and so the term of
trade become unfavourable.

• (3) Availability of Substitutes : If the substitutes of the import

goods become available in the same country, then terms of
trade will be favourable to it. If the substitutes of the goods
exported become available in the foreign countries then terms
of trade will be unfavourable to the exporting country.
(4) Tastes and preferences of the People : The people of a country have
a craze for imported goods and they give preference to their
consumption, then terms of trade will be unfavourable to the country.
People have little preference for imported goods, terms of trade will
become favourable to the country.
(5) Size of population : Intensity of demand for imported goods is
relatively more for a country having large population. Terms of trade
will be favourable for a country having small population.
(6) Change in factor endowments and technology : With increase in the
availability of factor endowments and use of improved technology,
export will increase more than imports.
(7) Effects of Tariff : Other things being equal with increase in custom
duties, import falls. Consequently, terms of trade will become
favourable
(8) Devaluation : as a result of devaluation exchange rate of the
currency of the country depreciates. It may lead to favourable or
unfavourable terms of trade.
Lesson 4 - Unfavourable Trend in Terms of Trade
of Developing Countries
• i) Predominance of primary products: Raw materials and
agricultural produce are larger exports of developing
countries. Developing countries mainly export primary
agricultural products. It fetches low prices in the
international market and lowers their export receipts
• (ii) Heavy importation of finished goods. Developing
countries heavily import finished manufactured goods.
Their prices are very high. So, they have to spend more on
them.
• (iii) Backward technology. Developing countries use
obslete technology in production. It leads to lower quality
of their export hence lowering their price, demand and
revenue receipts.
• (iv) High reliance on foreign funds: Excess
reliance on foreign borrowing, aid borrowing .
Such loans are repaid with interest
• (v) Vulnerable to natural calamities. Many
developing countries are easily affected by
natural disasters. Drought also adversely affects
their production.
• (vi) High demand for foreign goods. Most
consumers in developing countries (in belief that
they are of better quality) hence end up spending
more on them
• (vii) Unfavourable world economic order: Developing
countries have low bargaining power in formulating world
economic policies. The developing countries have very little
say in international trade fora. They cannot influence the
world economic order in their favour hence end earning
less on exports /spending more on imports
• (viii) Low foreign investment: Developing countries are
unable to attract foreign investment leading to low capital
inflows, so, foreign receipts are low.
• (ix) Diminishing Export Demand: Diminishing demand for
exports of developing countries. It lowers their earnings.
• (x) Low production of export goods and services: It causes
low volume of exports leading to lower export earnings.
• (xi) Devaluation and depreciation of foreign currencies
reduces export earnings
• (xii) Appreciation or revaluation of local currency leads
to lower export earnings
• (xiii) Political instability and insecurity also lowers
export earnings
• (xiv) Protectionism policies by other country that lead
to fewer exports and earnings
• (xv) Withdrawal of foreign aid and grants leading to
capital flight /outflows
• (xvi) Poor governance, policies and corrupt practices
lead to low export earnings and low capital flows.
• (xvii) Unfavourable terms of trade leading to low
export earnings high expenditure on imports
Lesson 5 – Effects of Tariff under
Partial Equilibrium Analysis

Equilibrium Analysis

Partial Equilibrium General Equilibrium

Alfred Marshal Leon Walras

 Partial Equilibrium Analysis
• 1. Marshall’s Partial Equilibrium Analysis
• Partial equilibrium approach seeks to explain the
price determination of a commodity, keeping the
prices of other commodities constant and also
assuming that the various commodities are not
interdependent
• It is based on the assumption that the changes in
a single sector do not significantly affect the rest
of the sectors. Thus, in partial equilibrium
analysis, if the price of a good changes, it will not
affect the demand for other goods.
 Walras General Equilibrium

• In general equilibrium analysis, the price of a

good is not explained to be determined
independently of the prices of other goods. Since
the changes in price of good X affect the prices
and quantities demanded of other goods and in
turn the changes in prices and quantities of other
goods will affect the quantity demanded of the
good X, the general equilibrium approach
explains the simultaneous determination of
prices of all goods and factors
 Tariffs
• A tariff is a type of trade barrier that takes the
form of tax on imports. The tariff may be in
the form of a specific or ad valorem tax. Tariffs
raise the price of the imported good to lower
its consumption. Tariffs encourage consumers
to pick the local commodity.
• It is trade barrier.
• It is a protectionist tool
 Lesson – 6: Effects of Tariffs under Partial
Equilibrium – Small country small industry case

• When a small country imposes tariff on import

of the product that competes with the
product of the small domestic industry, the
tariff can neither affect the international
prices (as the country is small) nor can it affect
the rest of the economy (as the industry is
small). In such conditions, the partial
equilibrium analysis that concerns the market
for a particular product becomes the most
appropriate.
 Assumptions
• (i) The demand and supply curves of the given
commodity are concerned with home country that
imposes import tariff.
• (ii) The given demand and supply curves remain constant.
• (iii) There is no change in consumers’ tastes, prices of
other commodities and money income of the consumers.
• (iv) There is an absence of technological improvements,
externalities and other factors that result in changes in
cost conditions.
• (v) No tariff is imposed by the home country on the
import of materials that are required for producing the
given commodity.
• (vi) Imported product and home-produced
product are perfect substitutes.
• (vii) There is no change in the foreign price of
the commodity.
• (viii) There is an absence of transport costs.
• (ix) The foreign supply curve of commodity is
perfectly elastic.
• (x) Domestic production of commodity takes
place at increasing costs.
Kindelberger’s List of eight effects of tariff in a partial
equilibrium approach

• 1.Protective or Production Effect

• 2. Consumption Effect
• 3. Revenue Effect
• 4. Redistribution Effect
• 5. Terms of Trade Effect
• 6. Competitive Effect
• 7. Income Effect
• 8. Balance of Payments Effect.
 1. Protective or Production Effect:
• The imposition of tariff may be intended to protect the
home industry from the foreign competition. As tariffs
restrict the flow of foreign products, the home producers
find an opportunity to increase the domestic production of
import substitutes. That is why the protective or production
effect of tariff is also termed as the import-substitution
effect.
• In order to analyse the production and other effects
diagrammatically, it is assumed that the world supply of the
given commodity is perfectly elastic so that it is available at
the constant price and the world supply curve is perfectly
elastic. The domestic production of the commodity is
possible, it is assumed, at an increasing cost. Therefore, the
domestic supply curve is positively sloping. The domestic
demand curve of the commodity, as usual, slopes
negatively.
• In Fig., demand and supply are measured along the horizontal scale
and price along the vertical scale. D and S are the domestic demand
and supply curves of the given commodity respectively. Originally
PW is the world supply curve of the commodity and the pre-tariff
price is OP. At the price OP, the domestic supply is OQ and demand
is OQ1.
• The gap QQ1 between demand and supply is met through import of
the commodity from abroad. If PP1 per unit tariff is imposed on
import, the price rises to OP1 and world supply curve shifts to P1W1.
At this higher price, the demand is reduced from OQ1 to OQ2
whereas the domestic supply expands from OQ to OQ3.
• Thus the domestic production of import substitutes rises by the
extent of QQ3. This is the protective, production or import
substitution effect. The increased domestic production reduces the
demand for foreign product from QQ1 to Q2Q3.
• In case the per unit tariff were PP2 causing the
price to rise to OP2, the domestic production
would have expanded large enough to meet
fully the domestic demand. In such a
situation, imports would have been reduced
to zero.
 Redistribution Effect
• The imposition of tariff causes a reduction in consumer‟s
satisfaction and also provides a larger producer‟s surplus or
economic rent to domestic producers and revenues to the
government. Thus tariff leads to redistributive effect in the
tariff-imposing country. The redistributive effect can be
shown with the help of diagram.
• Loss in Consumer‟s Surplus = RHP – RCP1 = PHCP1
• Gain in Producer‟s Surplus = TBP1 – TAP = PABP1
• Gain in Revenues to the Government = BCEF
• Net Loss = PHCP1 – (PABP1 + BCEF)
 Revenue Effect
• The imposition of import duty provides revenues to the
government. The revenue receipts due to tariff signify
a revenue effect. In the diagram the original price OP
does not include any tariff and no revenue receipts
become available to the government.
• Subsequently when PP1 per unit tariff is imposed, the
revenue receipts of the government can be determined
by multiplying per unit tariff PP1 (or BF) with the
quantity imported Q3Q2 or (EF). Thus the revenue
receipts due to tariff amount to PP1 × Q3Q2 = BF × EF =
BCEF. This is revenue effect of tariff.
• = ΔBAF + ACEH
• Kindelberger calls this net loss as the
“deadweight loss” due to tariff. It signifies the
cost of tariff. It is clear that tariff causes a
redistribution of income or satisfaction in the
given country. Consumers suffer a loss while
producers and government make a gain.
 Terms of Trade Effect
• The traditional theorists believed that tariff led to an improvement
in the terms of trade of the tariff-imposing countries. The modern
theorists, however, do not hold such a simplistic view. In their
opinion, the terms of trade, consequent upon the imposition of
tariff, depend upon the elasticities of demand and supply of
products of the two trading countries.
• If the foreign supply of a good is perfectly elastic or if the foreign
suppliers are ready to supply the product at a constant price, the
imposition of tariff is not likely to improve the terms of trade for
the tariff-imposing country. In case the foreign supply of a good is
not perfectly elastic, the imposition of tariff can have varying
effects upon the terms of trade of the tariff-imposing country
depending upon the elasticities of demand and supply in the two
trading countries. It has been explained through the diagram.
• In diagram, country A is an importing and country B is an exporting country.
The domestic demand and supply curves of the exporting country B are less
elastic. Country B imposes per unit tariff of P0P2 amount for reducing import
of the commodity. Since the domestic demand is inelastic, the surplus product
of country B can be disposed of in the other country A. Therefore, the
exporters lower the price of the commodity by P1P0. So P0P1 part of tariff is
borne by exporters and P1P2 part of it by the importers.
• If the tariff burden borne by importers in country A is less than the burden
borne by the exporters i.e., P1P2 < P1P0, the rise in price of the commodity in
country A is less than the fall in the export price of the commodity in country
B. In such a situation, the terms of trade become favourable to the tariff-
imposing country A.
• In case, P1P2 is more than P1P0, the rise in price of the commodity in country A
being larger than the fall in export price of the commodity in country B, the
terms of trade get worsened for country A. It can happen when the elasticities
of demand and supply for the commodity in country B are relatively more than
in country A.
 Income Effect
• The imposition of tariff reduces the demand for foreign
products. The amount of money not spent on imported
goods may either be spent on the home-produced goods or
saved. If there is the existence of surplus productive
capacity in the home country, switching of expenditure by
consumers from foreign to home-produced goods will lead
to a rise in production, employment and income.
• Alternatively, if the money not spent on foreign products
is saved, it results in greater accumulation of capital. The
financing of investment through additional saving can
again enlarge the productive capacity and income in the
tariff-imposing country. The expansionary effect of
reduction in imports upon domestic income can be shown
through diagram.
• If investment and export are assumed to be autonomous,
the investment plus export function (I + X) can be
drawn. Assuming saving and import to be positively
related with income, saving plus import function (S + M)
can be drawn.
• The intersection between I+X and S + M results in the
original equilibrium at E0 and the original equilibrium
income is Y0. If tariff causes a reduction in imports by
δM, the S+M function shifts down to S+M+(-δM). The
intersection between I+X and S+M+ (-δM) function at
E1 determines the equilibrium income at a higher level
Y1. The expansion in income Y0Y1 is much more than
the change in imports measured by the vertical distance
between S+M and S+M+(-δM) curves on account of the
reverse operation of import multiplier.
• The income effect due to tariff may not actually take place even
under a less than full employment situation for two reasons.
• Firstly, the imposition of tariff by the home country hits the exports
of the foreign country. Such a policy, if raises income, has such an
effect at the cost of the foreign country, the exports of which decline
resulting in a contraction in its output, employment and income.
Joan Robinson and many other economists have called such a trade
policy as a „beggar-my-neighbour‟ policy.
• In due course of time, such policies can have adverse effects even
upon the tariff-imposing country. The reduced exports of a foreign
country will lower its income. The foreigners will be able to buy less
products from the tariff-imposing country. Thus even the latter will
also experience a decline in the demand for its products and
consequent decline in its income.
• Secondly, the foreign countries may adopt retaliatory
tariff and other counterveiling measures and neutralise
any advantage obtained by the home country and the
desired income effect may fall to materialise.
• If the home country is in a state of full employment, the
tariff causing a reduction in imports and switch of
expenditure to the home-produced goods, will not
contribute in raising the output. Consequently, the
inflationary pressures alone will be felt. There may be an
increase only in money income and the real income,
output or employment will remain unaffected.
 Balance of Payments Effect
• When tariff is imposed by a country upon foreign products, the
home-produced goods become relatively cheaper than the imported
goods. The price effect caused by tariff reduces imports from other
countries and also causes increased production and purchase of
home- produced goods. That leads to a reduction in the balance of
payments deficit of the home country. It may be illustrated also
through the first diagram.
• Before the imposition of tariff, the quantity imported was QQ1. The
price being OP or AQ, the value of import or payment for import
was AQ × QQ1 = QAHQ1. After the imposition of tariff, the price is
OP1 or BQ3 and quantity imported is reduced to Q2Q3.
• The value of import is Q3BCQ2 out of which BFEC is the revenue
receipts of the government of the tariff- imposing country so that the
net payment to foreigners for import is Q3FEQ2, which is less than
the payment for imports before tariff. Needless to say that tariff can
cause a reduction in the balance of payments deficit of the tariff-
imposing country.
 !!!
• In this regard, some doubts are raised that tariff may
fail to improve the balance of payments deficit. Firstly,
if the demand for imports in the tariff- imposing
country is inelastic, tariff may not reduce the volume of
imports despite the rise in the prices of imported goods
consequent upon the imposition of tariff.
• Secondly, if the balance of payments disequilibrium is
caused by the export surplus, the imposition of tariff
will further aggravate rather than adjust the balance of
payments disequilibrium. Thirdly, tariff can, at the
maximum, bring about some adjustment in temporary
disequilibrium of international payments. There is no
possibility of adjusting the fundamental disequilibrium
in the balance of payments through tariff restrictions.
!!!
 Lesson 7 - Effects of Quota

• Quotas are are non- tariff trade barriers (NTBs).They have

been on the rise since 1960s. An import quota is a physical
restriction on the quantity of goods that may be imported
during a specific time period. The quota generally limits
imports to a level below that which would occur under free
trade conditions. For example a quota might state that no
more than 20 tonnes of sugar during some specific time
period.
• Quota Vs Tariff
• One of the features of quota is that their use may
lead to domestic monopoly of production and higher prices.
Because a domestic firm realizes that foreign producers
cannot surpass their quotas, it may raise its price. Tariffs do
not necessarily lead to monopoly power, because no limit is
established on the amount of goods that can be imported into
the nation.
 Seven Effects of Quota
• 1. Price Effect
• 2. Terms of Trade Effect
• 3. Balance of Payments Effect
• 4. Protective Effect
• 5. Consumption Effect
• 6. Re-distributive Effect
• 7. Revenue Effect
 Price Effect
• Import quotas limits physical omport quantities. It raises the
prices of commodities. By how much the price of the
commodity will rise depend upon the quantity of the good
fixed, the degree of elasticity of domestic and foreign supply
of the commodity and the nature of demand for it.
• If the demand for the commodity is highly inelastic and quota
fixed is practically half of what used to be imported before
under free trade, price of the commodity will rise considerably
than if the demand were elastic and quota fixed was of
considerable amount. Hence the price change due to quotas is
far less predictable.
• Originally, the price of the commodity was Po and the quantity
imported amounted to QQ1. The government of the home
country fixes the import quota to the extent of Q2Q3.
• The initial total supply in the home market
consists of OQ as the domestic output and QQ1 as
the import. It amounts to OQ + QQ1 = OQ1.
• After fixing of import quota, the total supply is
OQ3 out of which domestic production is OQ2 and
import quota is Q2Q3 (OQ3 = OQ2 + Q2Q3).
• It shows a shortage of the commodity compared
with the original situation. As a consequence,
given the supply OQ3 and demand curve D, the
price rises from P0 to P1. This rise in the price of
the commodity is the price effect of import quota
 Protective or Production Effect
• An import quota has a protective effect. As it
reduces the imports, the domestic producers are
induced to increase the production of import
substitutes. The increased domestic production
due to import quota is called as the protective or
production effect. As diagram shows originally
the domestic production was OQ. After the import
quota is fixed at Q2Q3, the domestic production
expands from OQ to OQ2. Thus there is an
increase in domestic production by QQ2. This is
the protective or production effect
 Consumption Effect
• After the import quota is prescribed, there is a rise
in the domestic price of the given commodity. As a
consequence, the consumption of the commodity
gets reduced. This is known as the consumption
effect. Diagram shows the consumption under free
trade situation is OQ1. After the fixation of import
quota up to Q2Q3, the total consumption at the
higher price P1 is reduced to OQ3. Thus there is a
reduction in consumption by OQ1 – OQ3 = Q1Q3,
subsequent to the fixation of import quota. This is
the consumption effect
 Revenue Effect
• Unlike tariff, the revenue effect of import quota is complex
and difficult to determine. If the government follows the
policy of auctioning the import licenses, the revenue
accruing to the government will amount to P0P1 ×
Q2Q3=GHKF. Such a revenue effect is equivalent to the
revenue effect in the event of equivalent tariff. But in fact
the governments do not auction the import licenses in recent
times.
• In such an event, the revenue effect is either captured by the
domestic importers or foreign exporters, or shared between
the domestic importers and foreign exporters in some
proportion. It is, therefore, not easy to quantify exactly what
the revenue effect of import quota will be and to which
group or groups will it accrue and in which proportion
 Redistributive Effect
The fixation of import quota leads to a rise in the price of the given
commodity. It may result in a loss in consumer‟s surplus for the
importing country. At the same time, higher price and increased
production ensures a gain in producer‟s surplus. Thus import quota
causes redistributive effect in the quota enforcing country. After the
fixation of import quota, the price rises from P0 to P1 and the loss in
consumer‟s surplus amounts to P0EFP1.
• The gain is producer‟s surplus amounts to P0CGP1. If importers are
organised, an amount equal to the revenue effect GHKF will accrue
to them. Consequ-ently, the net loss to the community will be
P0EFP1 – (P0CGP1 + GHKF) = ΔGCH + ΔFKE. If the revenue effect
neither accrues to the government nor to the importers, the
redistribution effect will involve a large net loss in welfare. In this
case, the net loss in welfare will amount to P0EFP1 – P0CGP1 =
GCEF
 Balance of Payments Effect
• One of the objectives of enforcing import quota is to reduce
the balance of payments deficit by restricting imports. That
portion of national income going into imports can be
utilised for investment in the import- substitution or export
industries. The expansion in exports, coupled with
restriction of imports is likely to bring about improvement
in the balance of payments position of the country.
• The quantity imported under free trade conditions at the
price P0 is QQ1 and the total value of imports is QCEQ1. In
case, the government prescribes the imports quota as Q2Q3,
the physical quantity imported has been slashed.
• Since price of imported commodity rises to P1, the
value of imports is Q2GFQ3. If the government
auctions the import licenses, its revenue receipt is
GFKH. Alternatively, if the importers are
organised, the gain due to higher price in the form
of additional profit can be obtained by them. In
either of the case, there can be saving of foreign
exchange of the size of GFKH and actual
payment to foreign country is Q2HKQ3 which is
less than the payment QCEQ1 for imports under
the free trade. Thus import quota brings about a
reduction in the balance of payments deficit.
 Terms of Trade Effect
• The imposition of import quota can influence the terms of trade of a
country in a favourable or unfavourable way depending upon the
elasticity of the offer curve or monopolistic and monopoly power of the
importing and exporting countries respectively. If the offer curve of
importing country is elastic or it has a monopsony power, the terms of
trade will become favourable to it.
• On the contrary, if the offer curve of exporting country is elastic or it has
some monopolistic control on the given commodity, the terms of trade
are likely to become favourable for it and unfavourable for the importing
country.
• The terms of trade effect of import quota may be uncertain and
indeterminate. Kindelberger says “As in the case of bilateral monopoly-
with a monopoly buyer and a monopoly seller, the outcome is
theoretically indeterminate.” The terms of trade effect of import quota
can be explained through diagram. Cloth is the exportable commodity
and steel is the importable commodity of the quota-imposing home
country A. OA is the offer curve of country A and OB is the offer curve
of foreign country B
• Originally P is the point of exchange and the terms of trade
are measured by the slope of the line OP. If the county A
imposes an import quota OS upon the importable
commodity steel, the exchange can take place either at P1 or
P2. If P1 is the point of exchange, the terms of trade are
measured by the slope of the line OR. Since OR is more
steep than OP, the terms of trade become favourable to the
home country A.
• On the opposite, if exchange takes place at P2, the terms of
trade are measured by the line OR1 which is less steep than
OP. In this case, the terms of trade become unfavourable to
the quota-imposing country A. It shows that the terms of
trade may be uncertain or indeterminate consequent upon
the enforcement of a specified quota upon imports