Tariffs, Import Quotas and International Trade

Put a $10 tax on every imported pair of sneakers. Sneaker makers at home win. The government collects money. Yet buyers lose more than those two gain, so the country as a whole ends up worse off. Where does the missing money go? This is Module 2.9: international trade and public policy.

Start with a country that doesn't trade at all. Economists call that autarky. The price is set where domestic supply meets domestic demand. In our sneaker market, that's $70 a pair, with 50,000 pairs sold each month. Now open the border. Sneakers also sell around the world at one price, the world price. Here it's $50, and our country is small enough to buy as many pairs as it wants at that price. Nobody here will pay $70 when the world sells for $50, so the domestic price falls to the world price. On a graph, draw it as a flat line labeled world price.

Quick refresher: to read a quantity at a price, go across from that price to a curve, then straight down to the quantity axis. Across to demand gives quantity demanded. Across to supply gives quantity supplied.

At $50, quantity demanded here is 90,000 pairs, read off the demand curve. Quantity supplied by domestic makers is only 30,000, read off the supply curve. Imports fill the gap: 90,000 minus 30,000 is 60,000 pairs.

So what just happened when the border opened? One: the price fell from $70 to the $50 world price. Two: quantity demanded rose to 90,000, and domestic quantity supplied fell to 30,000. Three: imports fill the 60,000 gap.

Exam trap: imports are the horizontal gap between quantity demanded and quantity supplied at the world price. Not the whole quantity demanded, and not the change from the old equilibrium.

Quick refresher: consumer surplus is the area under demand and above the price. Producer surplus is the area above supply and below the price. Watch both areas as the price line drops from $70 to $50.

Buyers gain consumer surplus, and domestic makers lose some producer surplus. Buyers gain more than makers lose, so total surplus rises. That extra triangle is the gain from trade.

Flip it. If the world price were $80, above the autarky price, domestic makers would supply 60,000 pairs, but buyers here would want only 30,000. Quantity supplied is greater than quantity demanded, so the extra 30,000 pairs are exported. Producers gain, buyers lose, and total surplus still rises.

Quick refresher: a triangle's area is one half, times its base, times its height. For consumer surplus, the height is where the demand curve hits the price axis, minus the price paid. The base runs from zero to the quantity bought.

Consumer surplus is now the small triangle under demand and above $80. Demand starts at $95, so it's one half, times $15, times 30,000: $225,000. Use the world price, not the old $70. Exam trap: domestic makers' revenue is the world price times the quantity they supply: $80 times 60,000 is $4.8 million. Not the 30,000 bought at home, or the old 50,000.

So what just happened in the export case? One: the $80 world price sits above the $70 autarky price. Two: quantity supplied, 60,000, is greater than quantity demanded, 30,000, so 30,000 pairs are exported. Three: makers earn $4.8 million, and consumer surplus shrinks to $225,000.

Back to imports at $50. A tariff is a tax on imported goods. Say the government puts a $10 tariff on each imported pair. Imported pairs now cost $60 here, so the domestic price rises to $60. On your graph, draw a second flat line there, labeled world price plus tariff.

Quick refresher: to read the new quantities, go across from $60 to each curve, then straight down to the axis.

At $60, domestic quantity supplied rises from 30,000 to 40,000 pairs, where the new line crosses supply. Quantity demanded falls from 90,000 to 70,000. So imports shrink to 70,000 minus 40,000, which is 30,000 pairs, half of the 60,000 before.

Quick refresher: a rectangle's area is height times width. On the graph, tariff revenue is a rectangle: its height is the $10 tariff, and its width is the 30,000 imports.

Tariff revenue is the tariff times imports after the tariff: $10 times 30,000 is $300,000 a month. Exam trap: don't multiply by the 60,000 imports from before the tariff. Those imports no longer arrive.

Quick refresher: consumer surplus sits under demand and above the price, and producer surplus sits above supply and below it. Now watch both areas as the price line lifts from $50 to $60.

Buyers pay $10 more, so consumer surplus falls. Domestic makers sell more at a higher price, so producer surplus rises.

So what just happened with the tariff? One: the $10 tariff lifted the price from $50 to $60. Two: domestic quantity supplied rose to 40,000 and quantity demanded fell to 70,000, so imports halved to 30,000. Three: the government collects $300,000, makers gain, and buyers lose.

Now, the missing money. There are two deadweight loss triangles, one on each side of the revenue rectangle. Exam trap: students find one and stop.

Quick refresher: a triangle's area is one half, times base, times height. For each triangle here, the base is a quantity gap on the axis, and the height is the $10 tariff.

The left one is wasted production. The extra 10,000 pairs made at home cost more than $50, the price the world would sell them for. One half, times 10,000, times $10, is $50,000. The right one is lost consumption: 20,000 pairs that buyers valued above $50 no longer get bought. One half, times 20,000, times $10, is $100,000. Total deadweight loss: $150,000 a month. That's the missing money. Add it up. Buyers lose $800,000 of consumer surplus. Makers gain $350,000, and the government collects $300,000. The last $150,000 goes to nobody: that's the country's net loss.

So what just happened to the missing money? One: the tariff got 10,000 extra pairs made at home at a cost above the $50 world price. Two: it priced out 20,000 pairs buyers valued above $50. Three: those two triangles, $150,000, are the country's net loss.

An import quota is a legal limit on how many units can come in. Set below free-trade imports, it works on quantities: fewer imports push the domestic price up, domestic makers produce more, and buyers buy less. Consumer surplus and total surplus fall, just like with a tariff. The difference: no tariff revenue. That money goes to whoever holds the import licenses. The AP exam won't ask you to graph a quota, but it can ask what one does to price, quantity and surplus.

Quick check, question 1. At the world price of $30, buyers here want 500 kayaks, and domestic makers supply 200. How many kayaks are imported? A) 300 B) 500 C) 200 D) 700

A, 300. Imports are quantity demanded minus domestic quantity supplied at the world price. The tempting answer is B, but domestic makers already cover 200 of those 500.

Question 2. A $4 tariff raises the domestic price of a toy from $20 to $24. Imports fall from 800 to 500. How much tariff revenue is collected? A) $3,200 B) $2,000 C) $1,200 D) $12,000

B, $2,000: $4 times the 500 imports that still arrive. The tempting answer is A, but $3,200 uses the 800 imports from before the tariff.

Free trade sets the domestic price at the world price, and the gap between quantity demanded and quantity supplied is your imports or exports. A tariff raises the price, shrinks imports, collects tariff times the new imports, and leaves two deadweight loss triangles. A quota cuts imports too, but with no tariff revenue. That's Unit 2.