Test Your Knowledge Flash Cards 🔒Play Lemonaire 🔒Play Last Stand

International Trade » Tariffs, Quotas and Subsidies

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 2.2.2 (c)

What tariffs, quotas and subsidies are and how each protects domestic producers
The advantages and disadvantages of each method
How to draw supply and demand diagrams for a tariff, a quota and a subsidy
How to read the world price, domestic supply, domestic demand and imports from a diagram

This topic is examined on Paper 2: Macroeconomics and the Global Economy.

🔒 Unlock Full Course Content

Unlock This Course

Three tools of protection

In Why Countries Protect Their Industries you met the reasons for protection. Now you need the methods. There are three to learn, and each works in a different way.

Key terms:

Tariff: a tax on imported goods.
Quota: a limit on the quantity of a good that can be imported.
Subsidy: money paid by the government to producers to help them cut their costs and prices (you met subsidies as a shifter of supply in What Shifts the Supply Curve).
World price: the price at which a good can be bought from the rest of the world.

🧾 Tariff

A tax added to the price of imports. Imports become dearer, so people buy fewer of them and more home-made goods. The government collects the tax.

🚧 Quota

A fixed limit on how many units can come in, for example 35,000 school bags a year. When the limit is reached, no more can be imported.

💷 Subsidy

Cash given to home producers. Their costs fall, so they can sell at a lower price and compete with imports. Imports are not taxed or limited.

Reading the diagram

All three diagrams use the same starting point: a country that can buy a good at the world price. Here is a made-up example. Country Lenvik buys school bags. The world price is £10 a bag. The table shows what happens (quantities are in thousands).

	Price paid by consumers	Domestic demand	Domestic supply	Imports
Free trade	£10	100	30	70
Tariff of £2	£12	80	45	35
Quota of 35	£12	80	45	35
Subsidy of £2	£10	100	45	55

How to draw the starting diagram:

Put Price (£) on the vertical axis and Quantity (thousands) on the horizontal axis.
Draw a downward-sloping demand curve and label it D (domestic demand).
Draw an upward-sloping supply curve and label it S (domestic supply).
Draw a horizontal line across the diagram at £10 and label it World price. It is flat because the country can buy as many bags as it likes at this price.
Where the world price line meets S, mark the quantity Q1 (30). This is what home firms make. Where it meets D, mark Q2 (100). This is what consumers buy. The gap between Q1 and Q2 is the imports (70).

Tariffs

A tariff is a tax on imports collected at the border, making foreign goods dearer

Drawing it: keep the diagram above. Draw a second, higher horizontal line at £12 (world price plus the tariff) and label it World price + tariff. Mark the new quantities: home supply rises to Q3 (45) and demand falls to Q4 (80). Imports shrink to the gap between Q3 and Q4 (35). The government's tariff revenue is the tariff per unit multiplied by the imports: £2 × 35,000 = £70,000. Shade the rectangle between £10 and £12 on the vertical axis and between Q3 and Q4 on the horizontal axis, and label it Tariff revenue.

✅ Advantages

Home firms sell more and can protect jobs. The government gains revenue. Imports fall, which can help a current account deficit.

❌ Disadvantages

Consumers pay a higher price and buy less. Home firms face less pressure to be efficient. Other countries may retaliate. Firms that use imported inputs face higher costs.

Quotas

A quota limits how much can be imported, like a cap on the number of foreign cars allowed in

Drawing it: start from the free-trade diagram.

Draw a new line, S + quota, to the right of S. At every price it sits 35 (thousand) further right than S, because home firms plus the allowed imports can supply that much.
Where S + quota meets D, mark the new price (£12) and the quantity bought, Q4 (80).
Read across to S at £12 to find home supply, Q3 (45).
Imports are the gap between Q3 and Q4 (35), the quota. The quantities match the tariff: home supply 45, demand 80, imports 35.

Foreign firms can only send 35,000 bags, so there is a shortage at the old price of £10 and the price rises to £12. Shade the rectangle between £10 and £12 and between Q3 and Q4 and label it Extra income for foreign sellers.

The big difference is who gets the extra £2 on each imported bag. With a quota, the government collects no tax. The extra money goes to the foreign firms or importers who are allowed to bring bags in.

✅ Advantages

Imports are limited to a known amount, so it is easy to protect home firms and jobs. A quota can help a current account deficit.

❌ Disadvantages

Consumers pay more and have less choice. The government earns no revenue. Foreign firms with a licence can gain from the higher price. Other countries may retaliate.

Subsidies

Drawing it: start from the free-trade diagram. Draw a new supply curve S1 to the right of (below) S, because the subsidy lowers costs. The world price line stays at £10, so consumers still pay £10 and demand stays at Q2 (100). But at £10 home firms now supply more: mark Q3 (45) where S1 meets the world price line. Imports fall to the gap between Q3 and Q2 (55). The cost to the government is the subsidy per unit multiplied by home output: £2 × 45,000 = £90,000.

✅ Advantages

Home firms produce more and jobs are kept. Prices to consumers do not rise, so consumers keep their choice and low prices. Home firms can sell abroad more cheaply.

❌ Disadvantages

The government pays, so it needs taxes or borrowing. That money could be used elsewhere (opportunity cost). Imports fall by less than with a tariff or quota. Inefficient firms may rely on the money. Other countries may object, and may retaliate.

Worked example

Country Lenvik adds a £2 tariff and imports fall from 70,000 to 35,000 bags. Tariff revenue = tariff × imports = £2 × 35,000 = £70,000. The price rises from £10 to £12, so each consumer pays 20% more (2 ÷ 10 × 100).

Common mistakes

Drawing the tariff line below the world price. A tariff adds to the price, so the line must be higher.
Saying a quota gives the government revenue. It does not. The extra money goes to foreign sellers.
Saying a subsidy raises the price for consumers. It keeps the price at the world price.
Forgetting to label axes, curves and the quantities. Unlabelled diagrams lose marks.

Exam-style question

Country Mirova can buy cotton shirts at a world price of £6. It places a tariff of £2 on each imported shirt. Before the tariff, imports were 500,000 shirts a year. After the tariff, imports are 300,000 shirts a year.

(a) Define the term tariff. [2 marks]

(b) Calculate the tariff revenue for the government of Country Mirova. [2 marks]

(d) Analyse one disadvantage of using a quota. [4 marks]

Model answer

(a) A tariff is a tax (1) on imported goods (1).

(b) Tariff revenue = tariff × imports (1) = £2 × 300,000 = £600,000 (1).

(c) With a tariff the price of imported shirts rises to £8 (1), so consumers pay more (1). With a subsidy the price stays at the world price of £6 (1) because home firms' costs are cut instead.

(d) A quota limits the quantity of imports (1). Supply is then smaller than demand at the old price, so the price of shirts rises (1). Consumers pay more and have less choice (1). The government receives no revenue, because the extra money goes to the foreign firms allowed to sell (1).

Exam tip

In a calculation, write the formula first, then the numbers. In part (b) you pick up a mark for the method even if your arithmetic slips.

Recap

A tariff is a tax on imports. It raises the price, cuts imports and earns the government revenue.
A quota limits the quantity of imports. It raises the price but the government earns nothing.
A subsidy cuts home firms' costs. It keeps prices low but costs the government money.
On the diagram, imports are the gap between domestic demand and domestic supply at the price paid.

Test Your Knowledge