Trade, Tariffs & the Cost of Protection

You’ll be able to

Show the effect of opening to trade on domestic price, quantity and surplus
Analyze a tariff's effect on consumer surplus, producer surplus, revenue and deadweight loss
Compare a tariff with an equivalent quota

Opening to trade at a world price

If the world price is below the domestic equilibrium, opening to trade lets consumers buy at the world price. Domestic quantity demanded rises, domestic quantity supplied falls, and the gap is imported. Consumer surplus rises by more than producer surplus falls, so total surplus rises — the gain from trade. If the world price were above the domestic price, the country would export instead, with producers gaining and consumers losing.

Tariff effects

consumer surplus ↓ · producer surplus ↑ · government revenue = tariff × imports · deadweight loss = two triangles (production and consumption distortion)

The consumer loss exceeds the producer gain plus the revenue. That excess is the deadweight loss, and it is the whole efficiency argument against tariffs.

Where the two deadweight triangles come from

A tariff raises the domestic price above the world price, producing two distortions. The production distortion is domestic output that costs more to make than the import would have — resources wasted on inefficient production. The consumption distortion is consumption forgone by buyers who valued the good above the world price but below the tariffed price. Both are pure losses: nobody captures them, unlike the revenue, which the government does collect.

A quota is a tariff without the revenue

An import quota caps the quantity imported. It raises the domestic price and produces the same two deadweight triangles as an equivalent tariff. The difference is what happens to the rectangle a tariff would have collected as revenue: with a quota it becomes quota rents captured by whoever holds the import licenses — possibly foreign producers. So a quota is at least as costly as an equivalent tariff and often worse, because the government forgoes the revenue.

Worked example

A country opens to trade at a world price below its domestic equilibrium, then imposes a per-unit tariff. Describe the effect of the tariff on each surplus component.

1.The tariff raises the domestic price from the world price toward the pre-trade price.
2.Consumers pay more and buy less: consumer surplus falls.
3.Domestic producers receive more and produce more: producer surplus rises.
4.Government collects the tariff on the remaining imports: revenue is the tariff times the reduced import quantity.
5.The consumer loss exceeds the producer gain plus the revenue; the difference is two deadweight loss triangles.

Answer: Consumer surplus falls, producer surplus and government revenue rise, and total surplus falls by the two deadweight triangles. Protection transfers surplus from consumers to producers and the government while destroying some of it outright.

Watch out

A tariff does not eliminate imports unless it is prohibitively large. Revenue is the tariff times the remaining imports, and computing it on the pre-tariff import quantity overstates it — a common arithmetic slip on this graph.

Checkpoint

A country with a domestic price above the world price opens to free trade. The result is that:

Checkpoint

Compared with a tariff that reduces imports by the same amount, an import quota:

Checkpoint

The deadweight loss from a tariff arises because:

On the exam

Label the world price line, the tariffed price line, and the four domestic quantities before computing any area. Trade-graph questions are almost entirely about reading areas correctly, and an unlabeled diagram makes that impossible to do reliably.

Answer the 3 checkpoints as you read.