Tariffs and Import Quotas in the Presence
of Monopoly
The trade policy analysis in this chapter assumed that markets are perfectly competitive, so
that all firms take prices as given. As we argued in Chapter 8, however, many markets for
internationally traded goods are imperfectly competitive. The effects of international trade
policies can be affected by the nature of the competition in a market.
When we analyze the effects of trade policy in imperfectly competitive markets, a new
consideration appears: International trade limits monopoly power, and policies that limit
trade may therefore increase monopoly power. Even if a firm is the only producer of a
good in a country, it will have little ability to raise prices if there are many foreign suppliers
and free trade. If imports are limited by a quota, however, the same firm will be free to
raise prices without fear of competition.
The link between trade policy and monopoly power may be understood by examining a
model in which a country imports a good and its import-competing production is controlled
by only one firm. The country is small on world markets, so the price of the import
is unaffected by its trade policy. For this model, we examine and compare the effects of
free trade, a tariff, and an import quota.
The Model with Free Trade
Figure 9A-1 shows free trade in a market where a domestic monopolist faces competition
from imports. D is the domestic demand curve: demand for the product by domestic residents.
is the world price of the good; imports are available in unlimited quantities at
that price. The domestic industry is assumed to consist of only a single firm, whose marginal
cost curve is MC.
PW
Price, P
Quantity, Q
MR
MC
D
PM
PW
Qf Df QM
Imports under free trade
Figure 9A-1
A Monopolist Under Free Trade
The threat of import competition
forces the monopolist to behave
like a perfectly competitive
industry.
216 PART TWO International Trade Policy
If there were no trade in this market, the domestic firm would behave as an ordinary
profit-maximizing monopolist. Corresponding to D is a marginal revenue curve MR, and
the firm would choose the monopoly profit-maximizing level of output and price .
With free trade, however, this monopoly behavior is not possible. If the firm tried to
charge , or indeed any price above , nobody would buy its product, because cheaper
imports would be available. Thus international trade puts a lid on the monopolist’s price
at .
Given this limit on its price, the best the monopolist can do is produce up to the point
where marginal cost is equal to the world price, at . At the price , domestic
consumers will demand units of the good, so imports will be . This outcome,
however, is exactly what would have happened if the domestic industry had been perfectly
competitive. With free trade, then, the fact that the domestic industry is a monopoly does
not make any difference in the outcome.
The Model with a Tariff
The effect of a tariff is to raise the maximum price the domestic industry can charge. If a
specific tariff t is charged on imports, the domestic industry can now charge
(Figure 9A-2). The industry still is not free to raise its price all the way to the monopoly
price, however, because consumers will still turn to imports if the price rises above the
world price plus the tariff. Thus the best the monopolist can do is to set price equal to marginal
cost, at . The tariff raises the domestic price as well as the output of the domestic
industry, while demand falls to and thus imports fall. However, the domestic industry
still produces the same quantity as if it were perfectly competitive.6
Dt
Qt
PW + t
Df Df - Qf
Qf PW
PW
PM PW
QM PM
6There is one case in which a tariff will have different effects on a monopolistic industry than on a perfectly competitive
one. This is the case where a tariff is so high that imports are completely eliminated (a prohibitive tariff).
For a competitive industry, once imports have been eliminated, any further increase in the tariff has no effect.
A monopolist, however, will be forced to limit its price by the threat of imports even if actual imports are zero.
Thus an increase in a prohibitive tariff will allow a monopolist to raise its price closer to the profit-maximizing
price PM.
Price, P
Quantity, Q
MR
MC
D
PM
PW
Qf Df Dt QM Qt
Imports under a tariff, t
PW + t
Figure 9A-2
A Monopolist Protected by a Tariff
The tariff allows the monopolist to
raise its price, but the price is still
limited by the threat of imports.
CHAPTER 9 The Instruments of Trade Policy 217
The Model with an Import Quota
Suppose the government imposes a limit on imports, restricting their quantity to a fixed
level . Then the monopolist knows that when it charges a price above , it will not lose
all its sales. Instead, it will sell whatever domestic demand is at that price, minus the
allowed imports . Thus the demand facing the monopolist will be domestic demand less
allowed imports. We define the post-quota demand curve as it is parallel to the domestic
demand curve D but shifted units to the left (Figure 9A-3).
Corresponding to is a new marginal revenue curve . The firm protected by an
import quota maximizes profit by setting marginal cost equal to this new marginal revenue,
producing and charging the price (The license to import one unit of the good
will therefore yield a rent of .)
Comparing a Tariff and a Quota
We now ask how the effects of a tariff and a quota compare. To do this, we compare a tariff
and a quota that lead to the same level of imports (Figure 9A-4). The tariff level t leads
to a level of imports ; we therefore ask what would happen if instead of a tariff, the government
simply limited imports to .
We see from the figure that the results are not the same. The tariff leads to domestic
production of and a domestic price of The quota leads to a lower level of domestic
production, , and a higher price, . When protected by a tariff, the monopolistic
domestic industry behaves as if it were perfectly competitive; when protected by a quota,
it clearly does not.
The reason for this difference is that an import quota creates more monopoly power
than a tariff. When monopolistic industries are protected by tariffs, domestic firms know
that if they raise their prices too high, they will still be undercut by imports. An import
quota, on the other hand, provides absolute protection: No matter how high the domestic
price, imports cannot exceed the quota level.
Qq Pq
Qt PW + t.
Q
Q
Pq - PW
Qq Pq.
Dq MRq
Q
Dq;
Q
Q PW
Imports = Q
Price, P
Quantity, Q
MRq
MC
D
Pq
PW
Dq
Qq Qq + Q
Figure 9A-3
A Monopolist Protected by an
Import Quota
The monopolist is now free to
raise prices, knowing that the
domestic price of imports will
rise too.
This comparison seems to say that if governments are concerned about domestic
monopoly power, they should prefer tariffs to quotas as instruments of trade policy. In fact,
however, protection has increasingly drifted away from tariffs toward nontariff barriers,
including import quotas. To explain this, we need to look at considerations other than economic
efficiency that motivate governments.
of Monopoly
The trade policy analysis in this chapter assumed that markets are perfectly competitive, so
that all firms take prices as given. As we argued in Chapter 8, however, many markets for
internationally traded goods are imperfectly competitive. The effects of international trade
policies can be affected by the nature of the competition in a market.
When we analyze the effects of trade policy in imperfectly competitive markets, a new
consideration appears: International trade limits monopoly power, and policies that limit
trade may therefore increase monopoly power. Even if a firm is the only producer of a
good in a country, it will have little ability to raise prices if there are many foreign suppliers
and free trade. If imports are limited by a quota, however, the same firm will be free to
raise prices without fear of competition.
The link between trade policy and monopoly power may be understood by examining a
model in which a country imports a good and its import-competing production is controlled
by only one firm. The country is small on world markets, so the price of the import
is unaffected by its trade policy. For this model, we examine and compare the effects of
free trade, a tariff, and an import quota.
The Model with Free Trade
Figure 9A-1 shows free trade in a market where a domestic monopolist faces competition
from imports. D is the domestic demand curve: demand for the product by domestic residents.
is the world price of the good; imports are available in unlimited quantities at
that price. The domestic industry is assumed to consist of only a single firm, whose marginal
cost curve is MC.
PW
Price, P
Quantity, Q
MR
MC
D
PM
PW
Qf Df QM
Imports under free trade
Figure 9A-1
A Monopolist Under Free Trade
The threat of import competition
forces the monopolist to behave
like a perfectly competitive
industry.
216 PART TWO International Trade Policy
If there were no trade in this market, the domestic firm would behave as an ordinary
profit-maximizing monopolist. Corresponding to D is a marginal revenue curve MR, and
the firm would choose the monopoly profit-maximizing level of output and price .
With free trade, however, this monopoly behavior is not possible. If the firm tried to
charge , or indeed any price above , nobody would buy its product, because cheaper
imports would be available. Thus international trade puts a lid on the monopolist’s price
at .
Given this limit on its price, the best the monopolist can do is produce up to the point
where marginal cost is equal to the world price, at . At the price , domestic
consumers will demand units of the good, so imports will be . This outcome,
however, is exactly what would have happened if the domestic industry had been perfectly
competitive. With free trade, then, the fact that the domestic industry is a monopoly does
not make any difference in the outcome.
The Model with a Tariff
The effect of a tariff is to raise the maximum price the domestic industry can charge. If a
specific tariff t is charged on imports, the domestic industry can now charge
(Figure 9A-2). The industry still is not free to raise its price all the way to the monopoly
price, however, because consumers will still turn to imports if the price rises above the
world price plus the tariff. Thus the best the monopolist can do is to set price equal to marginal
cost, at . The tariff raises the domestic price as well as the output of the domestic
industry, while demand falls to and thus imports fall. However, the domestic industry
still produces the same quantity as if it were perfectly competitive.6
Dt
Qt
PW + t
Df Df - Qf
Qf PW
PW
PM PW
QM PM
6There is one case in which a tariff will have different effects on a monopolistic industry than on a perfectly competitive
one. This is the case where a tariff is so high that imports are completely eliminated (a prohibitive tariff).
For a competitive industry, once imports have been eliminated, any further increase in the tariff has no effect.
A monopolist, however, will be forced to limit its price by the threat of imports even if actual imports are zero.
Thus an increase in a prohibitive tariff will allow a monopolist to raise its price closer to the profit-maximizing
price PM.
Price, P
Quantity, Q
MR
MC
D
PM
PW
Qf Df Dt QM Qt
Imports under a tariff, t
PW + t
Figure 9A-2
A Monopolist Protected by a Tariff
The tariff allows the monopolist to
raise its price, but the price is still
limited by the threat of imports.
CHAPTER 9 The Instruments of Trade Policy 217
The Model with an Import Quota
Suppose the government imposes a limit on imports, restricting their quantity to a fixed
level . Then the monopolist knows that when it charges a price above , it will not lose
all its sales. Instead, it will sell whatever domestic demand is at that price, minus the
allowed imports . Thus the demand facing the monopolist will be domestic demand less
allowed imports. We define the post-quota demand curve as it is parallel to the domestic
demand curve D but shifted units to the left (Figure 9A-3).
Corresponding to is a new marginal revenue curve . The firm protected by an
import quota maximizes profit by setting marginal cost equal to this new marginal revenue,
producing and charging the price (The license to import one unit of the good
will therefore yield a rent of .)
Comparing a Tariff and a Quota
We now ask how the effects of a tariff and a quota compare. To do this, we compare a tariff
and a quota that lead to the same level of imports (Figure 9A-4). The tariff level t leads
to a level of imports ; we therefore ask what would happen if instead of a tariff, the government
simply limited imports to .
We see from the figure that the results are not the same. The tariff leads to domestic
production of and a domestic price of The quota leads to a lower level of domestic
production, , and a higher price, . When protected by a tariff, the monopolistic
domestic industry behaves as if it were perfectly competitive; when protected by a quota,
it clearly does not.
The reason for this difference is that an import quota creates more monopoly power
than a tariff. When monopolistic industries are protected by tariffs, domestic firms know
that if they raise their prices too high, they will still be undercut by imports. An import
quota, on the other hand, provides absolute protection: No matter how high the domestic
price, imports cannot exceed the quota level.
Qq Pq
Qt PW + t.
Q
Q
Pq - PW
Qq Pq.
Dq MRq
Q
Dq;
Q
Q PW
Imports = Q
Price, P
Quantity, Q
MRq
MC
D
Pq
PW
Dq
Qq Qq + Q
Figure 9A-3
A Monopolist Protected by an
Import Quota
The monopolist is now free to
raise prices, knowing that the
domestic price of imports will
rise too.
This comparison seems to say that if governments are concerned about domestic
monopoly power, they should prefer tariffs to quotas as instruments of trade policy. In fact,
however, protection has increasingly drifted away from tariffs toward nontariff barriers,
including import quotas. To explain this, we need to look at considerations other than economic
efficiency that motivate governments.
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