Apr 15, 2012

Import quotas, tariffs and decisions under lack of complete information

There is some confusion regarding quotas, tariffs and their application among general public and even among some people who claim to know things. However, the attempt to explain a concept of  this nature in a blog is fraught with risk of being misunderstood. I cannot use mathematics and graphs in a general blog, and so I would try and connect them through some links to webpages. For preliminary understanding of quotas and tariffs one can follow the wiki. 

It is generally assumed that tariffs are better than quotas. And most of this misconception comes from the WTO rules, that somehow make it sound as if tariffs are better than quotas. Anything that reads 'quota' is abhorred in general and tarrification is considered the starting point of trade liberalization. If one reads elementary economics, one would see that quotas are more trade restrictive than tariffs. And the person reasons, along with WTO, that due to the trade restrictive nature of quotas, they shouldn't be used, unless there is an emergency of monetary or other sorts like injury to industry etc. For some reason, the elementary texts stop at that. If you go a little further, you will bump into Bhagwati's paper where he argues about tariffs and quotas being one and the same, producing same effects, under certain assumptions like free market and perfect competition. The welfare effect gains/losses can also be made same given the quotas are judiciously auctioned or sold (otherwise the quota benefits accrue to the seller or importer or the quota-issuing-bribe-taking bureaucrats). 

So, it is not that import quotas are bad as such, just that they appear to be more trade restrictive. However, there is one particular condition, which is more true in case of developing countries, where quotas appear to serve the purpose better than tariffs. Under 'lack of complete information' about the market supply and demand curves, quotas would work better if the government wants to control imports for some reason (to protect an industry, to nurture a new industry, or to protect an interest group etc). 

Lack of complete information might pertain to the lack of information regarding the supply curve or the demand curve. This means, in turn, that the government cannot be sure of the effects of tariffs. This is because the supply conditions is not a curve but a band now. It can be shown that (Weitzman, 1977, I am unable to locate the paper on web), the effect of tariff can vary from a small import to a huge deluge and the magnitude cannot be predicted. However, quotas under such case will ensure that the imports are under control. The price now is not a constant number like earlier, but varies in a band. However, that doesn't affect the goal of controlling imports. 

If the goal of government is to control imports to some certain degree, tariff is a blunt instrument unless all information and data regarding the economy and the industry is available in precise form. Given India's situation and the quality of data that's available, I am sure we are in an uncertain zone. Correct me if I am wrong. You just cannot predict the level of imports with any tariff in place. Too much of tariff will kill all imports, and too small a tariff will flood the market. The exact tariff cannot be easily determined, unless one is ready to do a trial and error, which again, is not scientific way of doing things. So it makes a lot of sense for Indian government to keep the quota option open in case it wants to control an import in a precise way. 

On a side note, IIIA of FTDR Act of India, introduced through a  notification in 2010 allows GoI to impose quotas under certain conditions. Someone told me that this can be challenged at WTO, which I doubt, given the wordings of this chapter.