Microeconomics guide, Unit 2, step 12 of 28Previous step Next step

Step 12: International Trade and Public Policy

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Micro 2.9 · Cambridge 6.2 · IB 4.2

In 30 seconds

When the world price is below a country’s own equilibrium price, free trade lowers the domestic price. Consumers buy more, domestic producers sell less, and the gap is filled by imports.
Consumers gain more surplus than producers lose, so free trade creates a net gain for the country.
A tariff (a tax on imports) raises the domestic price, cuts imports, earns revenue for the government and creates two deadweight loss triangles. A quota has the same price effect, but the revenue becomes “quota rent” for whoever holds the import licences.
Exam point: be able to shade and calculate consumer surplus, producer surplus, tariff revenue and deadweight loss on the diagram, and say who gains and who loses.

Video lesson coming soonA short animated lesson for this step will appear here.

Opening up to trade: what the world price does

Imagine your country grows its own oranges. Without trade, local demand and supply set the price, say $6 a box. Now the borders open, and foreign growers will sell as many boxes as you want at $3. Nobody will pay $6 for a local box, so the domestic price drops to the world price.

Key termWorld price ($ P_w $): the price at which a good can be bought or sold on the world market. A small country is a “price taker”: it can import as much as it wants at this price without changing it.

At the lower price, two things happen at once:

Domestic consumers move down their demand curve and buy more.
Domestic producers move down their supply curve and produce less, because some can no longer cover their costs at $3.

The difference between what consumers want to buy and what local firms produce is filled by imports:

\[ \text{Imports} = Q_d – Q_s \quad \text{at the world price} \]

(If the world price were above the domestic price, the opposite happens: local firms produce more than local consumers buy, and the country exports the difference. This step focuses on the import case.)

Who gains and who loses from free trade

To measure the gains, we use consumer surplus and producer surplus from the surplus step. Consumer surplus (CS) is the area below the demand curve and above the price. Producer surplus (PS) is the area above the supply curve and below the price.

Worked example

For example, the orange market has domestic demand $ Q_d = 120 – 10P $ and domestic supply $ Q_s = 10P $ (Q in thousands of boxes, P in $). The world price is $3. Compare the market without trade and with free trade.

Step 1No trade: $ 120 – 10P = 10P \Rightarrow P = 6,\ Q = 60 $. Demand hits zero at $ P = 12 $; supply starts at $ P = 0 $.

Step 2Surplus with no trade: $ CS = \tfrac{1}{2} \times 60 \times (12 – 6) = 180 $; $ PS = \tfrac{1}{2} \times 60 \times 6 = 180 $. Total $ = 360 $.

Step 3At $ P_w = 3 $: $ Q_d = 120 – 30 = 90 $, $ Q_s = 30 $, imports $ = 90 – 30 = 60 $.

Step 4Surplus with free trade: $ CS = \tfrac{1}{2} \times 90 \times (12 – 3) = 405 $; $ PS = \tfrac{1}{2} \times 30 \times 3 = 45 $. Total $ = 450 $.

Step 5Changes: consumers gain $ 405 – 180 = 225 $; producers lose $ 180 – 45 = 135 $; net gain $ = 225 – 135 = 90 $.

Free trade raises total surplus by 90 (in $ thousands). Check: the net gain is the triangle between the curves above the world price, $ \tfrac{1}{2} \times (90 – 30) \times (6 – 3) = 90 $. Consumers win, local producers lose, but the winners gain more than the losers lose.

DiagramDraw a normal demand and supply diagram for the domestic market, with “Price” on the vertical axis and “Quantity” on the horizontal axis. Mark the no-trade equilibrium at P = 6, Q = 60. Draw a horizontal line at the world price, P_w = 3, below the equilibrium. Where this line meets the supply curve, mark Q_s = 30; where it meets the demand curve, mark Q_d = 90. The horizontal distance between them (30 to 90) is imports. Consumer surplus is now the large triangle under demand and above P_w. Producer surplus shrinks to the small triangle above supply and below P_w. The triangle between the two curves, above P_w and below the old price, is the net gain from trade.

Of the consumers’ gain of 225, 135 is simply a transfer: it is the surplus domestic producers lost. The remaining $ 225 – 135 = 90 $ is new surplus that did not exist before trade.

Tariffs: taxing imports

Local producers who lose from free trade often ask the government for protection. The most common tool is a tariff.

Key termTariff: a tax on imported goods. A specific tariff is a fixed amount per unit (for example, $1 per box); an ad valorem tariff is a percentage of the import price.

A per-unit tariff raises the price of imports from $ P_w $ to $ P_w + t $. Domestic firms can now also charge this higher price, so the whole domestic market moves to the new price. Consumers buy less, local firms produce more, and imports shrink from both ends.

Worked example

Continue the orange market. The government puts a tariff of $1 per box on imports. Find the new price, imports, tariff revenue and deadweight loss.

Step 1New domestic price $ = P_w + t = 3 + 1 = \$4 $.

Step 2$ Q_d = 120 – 40 = 80 $; $ Q_s = 10 \times 4 = 40 $; imports $ = 80 – 40 = 40 $ (down from 60).

Step 3Tariff revenue $ = t \times \text{imports} = 1 \times 40 = 40 $.

Step 4Production deadweight loss $ = \tfrac{1}{2} \times (40 – 30) \times 1 = 5 $. Consumption deadweight loss $ = \tfrac{1}{2} \times (90 – 80) \times 1 = 5 $. Total DWL $ = 10 $.

Step 5New surplus: $ CS = \tfrac{1}{2} \times 80 \times (12 – 4) = 320 $; $ PS = \tfrac{1}{2} \times 40 \times 4 = 80 $. Total welfare $ = 320 + 80 + 40 = 440 $, which is $ 450 – 10 $.

Consumers lose $ 405 – 320 = 85 $. Of that, 35 goes to domestic producers (PS rises from 45 to 80), 40 goes to the government, and 10 is lost to nobody: that is the deadweight loss. Check: $ 35 + 40 + 10 = 85 $.

Reading the tariff diagram

DiagramStart from the free trade diagram. Draw a second horizontal line at P_w + t = 4, above the world price but below the no-trade price of 6. Read off the new quantities: domestic supply rises from 30 to 40, domestic demand falls from 90 to 80, and imports are now the gap from 40 to 80. Between the two price lines you get four areas, usually labelled from left to right:
Area a: the strip to the left of the supply curve, from 0 to 40. This is extra producer surplus.
Area b: the small triangle between the supply curve and the world price line, from 30 to 40. This is the production deadweight loss: local firms are now making 10 units that could have been imported more cheaply.
Area c: the rectangle from 40 to 80, height equal to the tariff. This is government revenue.
Area d: the small triangle between the demand curve and the world price line, from 80 to 90. This is the consumption deadweight loss: consumers who valued oranges above the world price no longer buy them.
The loss of consumer surplus equals a + b + c + d.

Group	Effect of the $1 tariff	Area	Value
Consumers	Pay more, buy less	−(a + b + c + d)	−85
Domestic producers	Higher price, sell more	+a	+35
Government	Tariff revenue	+c	+40
Society overall	Deadweight loss	−(b + d)	−10
Foreign exporters	Sell fewer units at the world price	(outside our diagram)	lose sales

Common mistakeCalculating tariff revenue as the tariff times the original imports (1 × 60). Revenue is only collected on goods that are still imported after the tariff: 1 × 40. A second mistake is drawing the tariff as a shift of the domestic supply curve. The domestic supply and demand curves do not move; only the price line moves up.

Import quotas and quota rent

Key termImport quota: a legal limit on the quantity of a good that can be imported in a period, usually enforced by issuing import licences.

Suppose instead of a tariff, the government allows only 40 thousand boxes to be imported. With imports fixed at 40, the price must rise until the domestic shortage equals 40: $ (120 – 10P) – 10P = 40 \Rightarrow 20P = 80 \Rightarrow P = \$4 $. That is exactly the same price as the $1 tariff. Consumers lose the same surplus, producers gain the same surplus, and the deadweight loss triangles (b and d) are the same size, 10 in total.

The difference is area c. Under a quota, there is no tax. Whoever holds an import licence can buy oranges abroad at $3 and sell them at home for $4, earning $ (4 – 3) \times 40 = 40 $. This is called quota rent.

If the government auctions the licences, it can capture the quota rent, just like tariff revenue.
If licences are given away to domestic importers, the rent goes to them.
If licences go to foreign exporters (as with “voluntary export restraints”), the rent leaves the country, so the home country’s total loss becomes $ 10 + 40 = 50 $ instead of 10.

Also, if demand rises, a tariff lets imports rise, but a quota keeps them fixed, so the domestic price climbs further.

Why protect at all? A quick look

If protection reduces total welfare, why use it? The main arguments are:

Infant industry: a new industry may need temporary protection until it grows big enough to compete.
Protecting jobs in industries hit by cheap imports, especially where workers find it hard to move to new jobs.
National security: a country may want its own supply of food, energy or defence equipment.
Anti-dumping: responding to foreign firms selling below cost to drive out local producers.
Government revenue, which matters more for countries with weak tax systems.

Against these: consumers pay higher prices, protected firms have less reason to become efficient, and trading partners may retaliate with their own tariffs, hurting exporters. The macroeconomics step on protectionism covers these arguments in depth.

Exam tipAP Micro FRQ: draw the domestic market with labelled axes (“Price”, “Quantity”), the domestic D and S, a horizontal line labelled P_w, and a second line labelled P_w + tariff. Label Q_s and Q_d at both prices, and identify imports as the horizontal gap. You will be asked to shade or calculate CS, PS, tariff revenue or DWL, so use the triangle formula $ \tfrac{1}{2} \times \text{base} \times \text{height} $ and show the numbers. Cambridge 9708 and IB: explain the chain (tariff → higher domestic price → domestic supply rises, demand falls → imports fall), then evaluate who gains and loses, and note retaliation and the loss of efficiency. IB Paper 3 often asks you to calculate the change in consumer and producer surplus, revenue and welfare loss from given figures.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A country’s domestic equilibrium price for bicycles is $50. The world price is $30. At $30, domestic demand is 500 bicycles and domestic supply is 200. Will the country import or export, and how many? Show worked answer

The world price is below the domestic price, so the country imports.
Imports $ = Q_d – Q_s = 500 – 200 = 300 $ bicycles.

EasyQ2. A government puts a tariff on imported steel. Name two groups that gain and two that lose. Show worked answer

Gain: domestic steel producers (higher price and more sales) and the government (tariff revenue). Workers in the domestic steel industry may also gain.
Lose: domestic buyers of steel, such as car makers and builders (higher price, less bought), and foreign steel exporters (fewer sales). Society as a whole also loses the deadweight loss.

MediumQ3. The world price of a good is $10. A tariff of $2 per unit is imposed. At the new price, domestic demand is 800 units and domestic supply is 500 units. Calculate the domestic price, imports and tariff revenue. Show worked answer

Domestic price $ = 10 + 2 = \$12 $
Imports $ = 800 – 500 = 300 $ units
Tariff revenue $ = 2 \times 300 = \$600 $

MediumQ4. In the market in Q3, before the tariff (at $10) domestic demand was 900 and domestic supply was 400. Calculate the fall in imports, the total deadweight loss, the gain in producer surplus and the loss in consumer surplus. Show worked answer

Imports before $ = 900 – 400 = 500 $; after $ = 300 $. Fall $ = 200 $ units.
Production DWL $ = \tfrac{1}{2} \times (500 – 400) \times 2 = 100 $
Consumption DWL $ = \tfrac{1}{2} \times (900 – 800) \times 2 = 100 $
Total DWL $ = \$200 $
PS gain (area a) $ = 2 \times 400 + \tfrac{1}{2} \times 100 \times 2 = 800 + 100 = \$900 $
CS loss $ = 2 \times 800 + \tfrac{1}{2} \times 100 \times 2 = 1{,}600 + 100 = \$1{,}700 $
Check: $ 900 + 600 + 200 = 1{,}700 $ ✓

MediumQ5. Instead of the tariff in Q3, the government sets an import quota of 300 units, which also raises the domestic price to $12. Calculate the quota rent and explain who might receive it. Show worked answer

Quota rent $ = (12 – 10) \times 300 = \$600 $, the same size as the tariff revenue.
It goes to whoever holds the import licences: the government if it auctions them, domestic importers if it gives them away, or foreign exporters if they control the licences. In the last case the $600 leaves the country, so the home country loses more than with a tariff.

ExamQ6. In a small country, domestic demand for rice is $ Q_d = 200 – 4P $ and domestic supply is $ Q_s = 4P $. The world price is $15. (a) Find the no-trade price and quantity. (b) Calculate imports under free trade. (c) A tariff of $5 per unit is imposed. Calculate the new price, imports and tariff revenue. (d) Calculate the deadweight loss. (e) State the change in consumer surplus and producer surplus. [10 marks] Show worked answer

(a) $ 200 – 4P = 4P \Rightarrow 8P = 200 \Rightarrow P = \$25 $; $ Q = 4 \times 25 = 100 $. [2 marks]
(b) At $15: $ Q_d = 200 – 60 = 140 $; $ Q_s = 60 $. Imports $ = 80 $. [2 marks]
(c) New price $ = 15 + 5 = \$20 $. $ Q_d = 200 – 80 = 120 $; $ Q_s = 80 $. Imports $ = 40 $. Revenue $ = 5 \times 40 = \$200 $. [3 marks]
(d) DWL $ = \tfrac{1}{2} \times (80 – 60) \times 5 + \tfrac{1}{2} \times (140 – 120) \times 5 = 50 + 50 = \$100 $. [1 mark]
(e) Demand reaches zero at $ P = 50 $. CS falls from $ \tfrac{1}{2} \times 140 \times 35 = 2{,}450 $ to $ \tfrac{1}{2} \times 120 \times 30 = 1{,}800 $: a loss of $650. PS rises from $ \tfrac{1}{2} \times 60 \times 15 = 450 $ to $ \tfrac{1}{2} \times 80 \times 20 = 800 $: a gain of $350. Check: $ 350 + 200 + 100 = 650 $. [2 marks]

Check yourself

1. If the world price is below a country’s no-trade equilibrium price, free trade will:

Buyers switch to the cheaper world supply, so the domestic price falls to P_w and the shortfall is imported.

2. Tariff revenue is equal to:

Only units that are still imported pay the tariff; domestic production pays nothing.

3. The key difference between a tariff and a quota that raise the price by the same amount is:

Price, quantities and DWL triangles are the same; only who gets area c changes.

Your score: 0 out of 3

The short version

With a world price below the domestic price, the domestic price falls to $ P_w $ and imports equal $ Q_d – Q_s $.
Free trade raises consumer surplus by more than it lowers producer surplus, so the country gains overall.
A tariff raises the price to $ P_w + t $: domestic output rises, consumption and imports fall, the government collects $ t \times $ imports, and two deadweight loss triangles appear.
A quota gives the same price and DWL, but area c becomes quota rent for licence holders, and imports cannot rise if demand grows.
Protection is defended on infant industry, jobs, security and anti-dumping grounds, but it costs consumers, protects inefficiency and risks retaliation.