If there is only one domestic automobile manufacturing firm in a small country, will there be a difference in terms of national economic well-being between using a tariff and using a quota to protect the firm? If so, what is the difference? Clearly explain your answer.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: If there is only one automobile manufacturing firm in the domestic economy, it would mean that this firm may have monopoly power in the domestic automobile industry. With free trade, the monopolist will lose its monopoly power completely. Facing competition from foreign producers, the monopolist will turn into a price taker that charges the international price. Now, if a tariff is imposed, the domestic producer will be able to charge a price equal to the world price plus the amount of the tariff, but the producer will still remain a price taker, because imports can still increase without limit at this price. If, instead, an import quota is used, there is no import competition at the margin, once the quota is filled. The domestic producer then will be able to determine the domestic price of the product by deciding how much to produce. A profit-maximizing monopolist will decide on its production quantity in such a way that the marginal revenue from the last unit produced equals the marginal cost of production of the last unit. With a quota, the monopolist will be able to charge a higher price by restricting production, knowing that domestic consumers cannot purchase imported automobiles beyond the quota quantity. Because the domestic price diverges more from the world price, the quota results in a larger inefficiency-a larger deadweight loss.