International Trade
& Public Policy

Explore how nations gain from trade through comparative advantage, and how tariffs and quotas reshape surplus, prices, and welfare.

AP Microeconomics

Why Do Nations Trade?

Countries trade because they differ in their ability to produce goods. Even if one country can produce everything more cheaply, trade still benefits both parties. The key insight: what matters is not absolute cost, but relative cost: the opportunity cost of production.

Exports

Goods produced domestically and sold abroad, earning revenue for domestic producers.

Imports

Goods produced abroad and purchased domestically, benefiting consumers with lower prices.

Comparative vs. Absolute Advantage

Absolute Advantage

A country can produce a good using fewer resources (or more output per unit of input) than another country.

Comparative Advantage

A country can produce a good at a lower opportunity cost than another country. This is the basis for mutually beneficial trade.

Computing Opportunity Cost

Suppose two countries each have 100 labor hours and can produce Wheat (W) or Cloth (C):

	Country A	Country B
Max Wheat	100 units	50 units
Max Cloth	50 units	40 units
OC of 1 Wheat	$\frac{1}{2}$ Cloth	$\frac{4}{5}$ Cloth
OC of 1 Cloth	2 Wheat	$\frac{5}{4}$ Wheat

The World Price and Domestic Markets

When a country opens to trade, the world price ($P_w$) determines whether it exports or imports a good. Compare $P_w$ to the domestic equilibrium price ($P_d$):

$P_w > P_d$

Domestic producers can sell abroad at a higher price. The country exports. Producers gain, consumers lose, but net surplus increases.

$P_w < P_d$

Consumers can buy imports more cheaply. The country imports. Consumers gain, producers lose, but net surplus increases.

Importing Country: Surplus Analysis

What Is a Tariff?

A tariff is a tax on imported goods. It raises the domestic price above the world price, shrinking imports and creating deadweight loss. The new domestic price with a tariff is:

1

Domestic price rises from $P_w$ to $P_w + t$.

2

Quantity demanded falls and quantity supplied rises domestically.

3

Imports shrink: the gap between $Q_d$ and $Q_s$ narrows.

4

Government collects revenue: $\text{Revenue} = t \times Q_{\text{imports}}$.

Tariff Effects: Deadweight Loss

Import Quotas

A quota is a legal limit on the quantity of imports. Like a tariff, it raises the domestic price and reduces imports, but the key difference lies in who captures the revenue rectangle.

Tariff

Revenue rectangle goes to the government as tax revenue.

Quota

Revenue rectangle becomes quota rents: captured by foreign exporters or domestic license holders.

Tariff vs. Quota: Side by Side

	Tariff	Quota
Mechanism	Tax on imports	Quantity limit on imports
Price Effect	Raises domestic price	Raises domestic price
Revenue	Government collects	Quota rents (foreign/license holders)
DWL Triangles	Two (a + b)	Two (a + b)
Net Welfare Loss	a + b	a + b + revenue rectangle*
Flexibility	Imports adjust if demand shifts	Fixed quantity regardless of demand

Surplus Effects of Trade Restrictions

When a tariff or quota is imposed on an importing country, the following changes occur relative to free trade:

1

Consumer surplus decreases. Consumers pay a higher price and buy less.

2

Producer surplus increases. Domestic producers sell more at a higher price.

3

Government revenue (tariff only): $\text{Revenue} = t \times Q_{\text{imports}}$.

4

Deadweight loss emerges: two triangles representing lost efficiency.

5

Total surplus falls. The loss to consumers exceeds the gains to producers + government.

How to Analyze a Trade Policy Problem

1

Identify the world price $P_w$ and compare it to the domestic equilibrium price $P_d$. Determine if the country imports or exports.

2

Draw the $S$ & $D$ diagram. Mark $P_w$, $Q_s$, and $Q_d$ at the world price. Label the imports or exports gap.

3

Apply the policy (tariff or quota). Mark the new price $P_w + t$ or the quota-restricted quantity. Find new $Q_s$ and $Q_d$.

4

Calculate surplus changes: change in CS, change in PS, government revenue (if tariff), and DWL.

5

Evaluate total welfare: sum up all changes. Confirm net loss equals the DWL triangles.

Example: Free Trade Surplus

A small country has domestic demand $Q_d = 100 - 2P$ and domestic supply $Q_s = 3P - 50$. The world price is $P_w = 20$. Find quantities and identify trade.

Example: Adding a \$5 Tariff

Using the same market, the government imposes a tariff of $t = 5$. The new domestic price becomes $P_w + t = 25$.

Example: Equivalent Quota

Instead of the tariff, the government imposes a quota of 25 units (the same import quantity the tariff produced). Compare the welfare effects:

	Tariff ($t = 5$)	Quota (25 units)
Domestic Price	\$25	\$25
Imports	25 units	25 units
CS Loss	Same	Same
PS Gain	Same	Same
Revenue/Rents	\$125 to govt	\$125 to license holders
DWL	\$62.50	\$62.50
Net Domestic Welfare Loss	\$62.50	\$62.50 + \$125*

Common Mistakes

✕ Confusing Absolute and Comparative

A country with absolute advantage in everything still benefits from trade. Focus on opportunity costs, not total output.

✕ Tariff Revenue = DWL

Government revenue from a tariff is not deadweight loss. It is a transfer. DWL is the two triangles only.

✕ Quotas and Tariffs Are Identical

They produce the same price and DWL, but differ in who gets the revenue rectangle. This matters for domestic welfare.

Question 1 of 5

Country A can produce 20 wheat or 10 cloth. Country B can produce 12 wheat or 8 cloth. Which country has the comparative advantage in cloth?

Country A's OC of 1 cloth = $\frac{20}{10} = 2$ wheat. Country B's OC of 1 cloth = $\frac{12}{8} = 1.5$ wheat. Since $1.5 < 2$, Country B has the lower opportunity cost of cloth, giving it the comparative advantage in cloth.

Question 2 of 5

When a small country opens to trade and the world price is below the domestic equilibrium price, which of the following occurs?

When $P_w < P_d$, consumers can buy imports at a lower price, so the country imports. Consumer surplus increases because consumers pay less. Producer surplus decreases because domestic firms face more competition at the lower price.

Question 3 of 5

A tariff on imported shoes raises the domestic price from $\$40$ to $\$50$. Imports fall from 200 to 120 units. What is the government's tariff revenue?

Tariff per unit: $t = \$50 - \$40 = \$10$. Imports after tariff: 120 units. Revenue $= t \times Q_{\text{imports}} = 10 \times 120 = \$1{,}200$. Note: use the post-tariff import quantity, not the original.

Question 4 of 5

Compared to an equivalent tariff, an import quota where licenses are given to foreign exporters results in:

When quota licenses go to foreign exporters, the revenue rectangle (quota rents) leaves the domestic economy entirely. The DWL triangles are the same, but the domestic economy also loses the rents. Total domestic welfare loss = DWL + quota rents, which is greater than the tariff's DWL alone.

Question 5 of 5

A country has $Q_d = 80 - P$ and $Q_s = 2P - 40$. The world price is $\$30$. A tariff of $\$6$ is imposed. What is the deadweight loss?

At $P_w = 30$: $Q_d = 80 - 30 = 50$, $Q_s = 2(30) - 40 = 20$. Imports = 30.
At $P_w + t = 36$: $Q_d = 80 - 36 = 44$, $Q_s = 2(36) - 40 = 32$. Imports = 12.
Left DWL: $\frac{1}{2}(6)(32 - 20) = 36$. Right DWL: $\frac{1}{2}(6)(50 - 44) = 18$.
Total DWL = $36 + 18 = \$54$.

International Trade& Public Policy

Why Do Nations Trade?

Comparative vs. Absolute Advantage

Computing Opportunity Cost

The World Price and Domestic Markets

Importing Country: Surplus Analysis

What Is a Tariff?

Tariff Effects: Deadweight Loss

Import Quotas

Tariff vs. Quota: Side by Side

Surplus Effects of Trade Restrictions

How to Analyze a Trade Policy Problem

Example: Free Trade Surplus

Example: Adding a \$5 Tariff

Example: Equivalent Quota

Common Mistakes

Question 1 of 5

Question 2 of 5

Question 3 of 5

Question 4 of 5

Question 5 of 5

International Trade
& Public Policy