With free trade, the United States can import an unlimited number of watches
at this price. At P $12.50, domestic demand is 25 million watches, which out-
strips the domestic supply of 15 million watches. Therefore, the United States
imports 10 million watches. In Figure 7.8a, the length of the line segment CD
measures this volume of imports, the difference between U.S. consumption and
U.S. production.
Now suppose the United States enacts trade restrictions prohibiting the
import of watches altogether. Then, the no-trade equilibrium price would
occur at the intersection of domestic supply and demand. In the figure, this
price is $15, and total output is 20 million watches.
What is the net effect of prohibiting watch imports? Domestic watch pro-
ducers benefit, while domestic consumers are harmed. We now show that the
cost to consumers exceeds the benefit to producers, thus causing a net loss in
the aggregate. To see this, note that the extra profits earned by domestic pro-
ducers due to the price increase (from $12.50 to $15) are given by the area of
trapezoid ABCE. (The extra profit lies between the old and new price lines and
above the industry supply curve.) However, the increase in price has sliced into
the total surplus of consumers. The reduction in consumer surplus is measured
by trapezoid ABDE. (This is simply the area between the two price lines and
under the demand curve.) When we compare trapezoids ABDE and ABCE, we
see that consumer losses exceed producer gains by the shaded triangle ECD.
This triangle measures the harm done to society, or the so-called deadweight
loss attributable to the trade prohibition.^15
Figure 7.8b depicts the effect of a less dramatic trade restriction. In this
instance, U.S. trade authorities have imposed a 12 percent tariff on Japanese
imports, raising the price of watches to (1.12)($12.50) $14. As shown in
the figure, the tariff reduces total U.S. consumption to 22 million watches,
while increasing domestic production to 18 million watches. Thus, U.S. imports
are 22 18 4 million watches. Although less extreme, the impact of the tar-
iff is qualitatively similar to that of a complete trade prohibition. Compared to
free trade, consumer surplus is reduced by trapezoid FBDI (the area between
the two price lines). Producer profits are increased by trapezoid FBCJ. The
trade authority also collects tariff revenue, given by rectangle JGHI, on
the 4 million watches imported. Comparing the loss in consumer surplus to
these twin gains, we see that the nation as a whole suffers a net loss measured
by the areas of the two shaded deadweight loss triangles.
We make two final observations. First, a tariff is superior to the alternative
of a quota that achieves an equivalent reduction in imports. A quota of 4 mil-
lion units would have exactly the same result as the 12 percent tariff, except that
it would raise no revenue. After eliminating the revenue rectangle JGHI, we
find the total deadweight loss of the quota to be trapezoid CDIJ. Second, moves(^15) For more on deadweight loss, see the discussion of market failure in Chapter 11.
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