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International Trade and Public Policy - Microeconomics

  1. Why does a tariff on an imported good create a 'production distortion' deadweight loss?
    Answer: It encourages domestic firms to produce units for which the domestic cost of production is higher than the world price. A tariff raises the domestic price above the world price. This higher price induces domestic firms to increase their output. The deadweight loss from production distortion arises because this extra domestic output costs more to produce (as shown by the supply curve) than it would cost to simply buy it from the world market (at the world price). Society is expending more resources to produce these goods at home than the value of the resources required to obtain them through trade. This misallocation of resources is the production distortion.
  2. A small country that imports textiles is considering an import quota to protect its domestic producers. If the government issues import licenses to foreign firms for free, how would the welfare effect of the quota compare to a tariff that restricts imports to the exact same quantity?
    Answer: The quota would result in a larger decrease in national welfare than the tariff. A tariff and a quota that restrict imports to the same level will have the same effect on consumer surplus, producer surplus, and deadweight loss. The key difference is the disposition of the revenue equivalent. With a tariff, the government collects revenue equal to (tariff per unit) x (quantity of imports). With a quota, this same value becomes 'quota rent'. If the government gives the licenses to foreign firms, this rent is transferred to foreigners, representing an additional loss to the importing country's national welfare compared to the tariff, where the revenue stays within the country.
  3. Two countries engage in trade where Country C exports 100 units of good X at $15 per unit and imports 80 units of good Y at $25 per unit. If Country C unilaterally eliminates all trade barriers while its trading partner maintains a 10% tariff on good X, what is the most likely outcome for Country C's economic efficiency?
    Answer: Efficiency increases because eliminating domestic distortions improves resource allocation regardless of partner policies When analyzing unilateral trade liberalization, focus on how eliminating domestic trade barriers affects your country's resource allocation, regardless of what trading partners do. The key insight is that trade barriers create domestic economic distortions that harm efficiency even when other countries maintain their own barriers. Country C's elimination of trade barriers improves economic efficiency because it removes domestic distortions that prevent optimal resource allocation. When you eliminate tariffs, quotas, or other barriers, domestic consumers gain access to goods at world prices, domestic producers face proper competitive pressure, and resources flow to their most productive uses. These efficiency gains occur independently of whether trading partners reciprocate with their own liberalization. Answer A incorrectly assumes that unilateral free trade creates unfairness that reduces efficiency. However, economic efficiency measures optimal resource use, not competitive balance between countries. Answer B makes the error of focusing primarily on export effects from the partner's tariff while ignoring the substantial domestic efficiency gains from eliminating import barriers. The 10% tariff on Country C's exports does create some deadweight loss, but this doesn't outweigh the efficiency improvements from domestic liberalization. Answer C wrongly claims trade barriers only affect distribution, not efficiency. Trade barriers actually create significant deadweight losses and misallocate resources across sectors. Remember this principle: a country benefits from eliminating its own trade barriers even when other countries don't reciprocate, because the primary gains come from improving domestic resource allocation, not from achieving "fair" trade relationships.
  4. The nation of Cascadia is a net exporter of lumber. If Cascadia engages in free trade in the lumber market, which of the following outcomes is certain to occur within its domestic market?
    Answer: Domestic consumer surplus will decrease, but the increase in domestic producer surplus will be larger. When a country becomes an exporter of a good, it's because its autarky (no-trade) price is below the world price. The domestic price will rise to the world price. This benefits producers, who can now sell more at a higher price, so producer surplus increases. However, domestic consumers are worse off because they face a higher price, so consumer surplus decreases. The fundamental principle of gains from trade states that the gains to the winners (producers in this case) outweigh the losses to the losers (consumers), leading to an increase in total national surplus.
  5. The domestic supply and demand for sugar in a small country are linear. In autarky, the price is $100 per ton. Under free trade, the world price is $60 per ton, and the country imports 1,000 tons. The government then imposes a tariff that raises the domestic price to $70 per ton. Assuming the supply and demand curves have not shifted, what is the new quantity of imports?
    Answer: 750 tons The gap between the autarky price ($100) and the world price ($60) is $40. This price gap corresponds to 1,000 tons of imports. Since the supply and demand curves are linear, the relationship between a price change and the change in the quantity of imports is also linear. The tariff raises the price from $60 to $70, a change of $10. This $10 price increase closes the price gap by $10/$40 = 1/4. Therefore, the quantity of imports will decrease by 1/4 of the original amount. The new import quantity will be 1,000−(1/4×1,000)=1,000−250=7501,000 - (1/4 \times 1,000) = 1,000 - 250 = 750 tons.
  6. A customs union is formed between Countries P and Q, eliminating tariffs between them while maintaining a common external tariff of 15% on imports from Country R. Before the union, all three countries traded freely. If Country P now imports good W from Country Q instead of from the lower-cost producer Country R, this represents:
    Answer: Trade diversion because it shifts imports from a more efficient producer to a less efficient union partner When analyzing customs unions, you need to distinguish between trade creation (efficiency gains) and trade diversion (efficiency losses). The key is whether trade shifts toward or away from the most efficient producer. In this scenario, Country P switches from importing good W from Country R (the lower-cost producer) to Country Q after the customs union forms. This happens because the 15% external tariff makes Country R's goods artificially expensive compared to Country Q's tariff-free goods within the union. Since P is now buying from a less efficient producer (Q) instead of the most efficient one (R), this represents trade diversion - answer D is correct. Answer A incorrectly focuses on trade volume rather than efficiency. While trade between P and Q increases, this doesn't automatically mean trade creation if it comes at the expense of more efficient trade relationships. Answer B identifies this as trade diversion but gives the wrong reason. The issue isn't simply that Country R loses export opportunities - it's specifically that trade shifts from a more efficient to a less efficient producer. Answer C confuses the mechanism with the outcome. While the customs union does eliminate internal tariffs and promote regional integration, the specific scenario described (importing from a higher-cost union partner instead of a lower-cost outside producer) represents trade diversion, not creation. Remember this pattern: trade creation occurs when unions enable trade that wouldn't otherwise happen efficiently, while trade diversion occurs when unions redirect trade away from the most efficient global producers toward less efficient union partners.
  7. Two countries, X and Y, trade freely in good Z. Country X can produce good Z at a constant cost of $5 per unit, while Country Y produces it at $8 per unit. If Country Y imposes a $2 per unit tariff on imports of good Z, and the world price remains at $5, what is the most likely outcome for resource allocation efficiency?
    Answer: Global efficiency decreases as Country Y shifts from low-cost imports to higher-cost domestic production With the tariff, Country Y's consumers face a price of $7 ($5 world price + $2 tariff), making some domestic production at $8 uncompetitive but closer to viability. However, any shift toward domestic production in Country Y represents a move from efficient ($5 cost) to less efficient ($8 cost) production, reducing global allocative efficiency. The tariff distorts the price signal that guides resources to their most productive uses. Choice A incorrectly suggests protection improves competitiveness rather than masking inefficiency. Choice C misunderstands that transfers don't eliminate real resource costs. Choice D ignores the efficiency costs of moving away from comparative advantage.
  8. The domestic market for a good in a small country has a price elasticity of demand of -1.5 and a price elasticity of supply of 2.0. The country imports this good. If the government imposes a 10% tariff, what is the most likely outcome?
    Answer: The quantity of imports will fall by more than the quantity of domestic production rises. A 10% tariff will raise the domestic price by 10%. Using the elasticities: domestic quantity demanded will fall by 15% (10% × 1.5), and domestic quantity supplied will rise by 20% (10% × 2.0). The change in imports equals the sum of the decrease in consumption and the increase in domestic production. Therefore, imports fall by more than production rises, since the import reduction includes both the consumption decrease and the production increase.
  9. Country A has a comparative advantage in producing wheat and imports steel from Country B. If Country A implements a $10 per ton tariff on steel imports, and the domestic steel industry experiences a 15% increase in production while consumer surplus decreases by $2 million, what can be concluded about the net welfare effect in Country A?
    Answer: Net welfare decreases because the deadweight loss from reduced trade exceeds any domestic producer gains A tariff creates deadweight loss by reducing mutually beneficial trade. The increase in domestic production and decrease in consumer surplus are classic signs of inefficient resource allocation. The tariff distorts comparative advantage, leading to higher-cost domestic production replacing lower-cost imports. While the government collects tariff revenue and domestic producers gain, these transfers don't offset the deadweight loss from reduced trade volume. Choice B incorrectly assumes transfers create net gains. Choice C misunderstands that tariff revenue is a transfer, not a net welfare gain. Choice D confuses economic efficiency with non-economic considerations.
  10. A small country is an importer of coffee. The world price of coffee rises significantly but remains below the country's autarky price. What are the effects of this world price increase on the country's domestic consumer surplus, producer surplus, and total surplus?
    Answer: Consumer surplus decreases, producer surplus increases, and total surplus decreases. When the world price rises, the domestic price for the imported good also rises. This makes domestic consumers worse off (consumer surplus decreases) and domestic producers better off (producer surplus increases). To find the effect on total surplus, consider the quantity of imports. As the domestic price rises, domestic quantity demanded falls and domestic quantity supplied rises, so the quantity of imports shrinks. The gains from trade are represented by a triangle whose area depends on the difference between the autarky price and the world price, and on the quantity of imports. As the world price gets closer to the autarky price, the volume of trade and the gains from it shrink. Therefore, total surplus decreases, though it remains higher than under autarky.
  11. A country imposes a 'tariff-rate quota' (TRQ) on sugar imports. This means that imports up to a certain quantity (the quota) are allowed at a low tariff rate, while any imports above that quantity are subject to a much higher tariff. If the country's demand for imports exceeds the quota level, what determines the domestic price of sugar?
    Answer: The world price plus the high tariff rate. With a TRQ, there are two potential prices. If import demand is less than the quota amount, the price will be the world price plus the low tariff. However, if import demand exceeds the quota amount, importers will have to bring in additional units that are subject to the high tariff. The marginal unit imported will be subject to this high tariff, and in a competitive market, the single domestic price will be driven up to the level of the world price plus the high tariff. The importers of the first units (within the quota) will earn a rent equal to the difference between the two tariff rates.
  12. A government imposes an import quota on agricultural products. To implement the quota, the government sells import licenses in a competitive auction. The total welfare effect of this policy for the importing country is:
    Answer: a net loss, because the loss in consumer surplus exceeds the gains in producer surplus and government revenue. An import quota, like a tariff, raises the domestic price, reduces consumer surplus, and increases producer surplus. When licenses are auctioned, the government collects revenue equal to the quota rent (the difference between the domestic price and world price, multiplied by the import quantity). This outcome is equivalent to a tariff that restricts imports to the same level. In either case, the policy creates production and consumption distortions, resulting in a deadweight loss. The loss to consumers is always greater than the combined gains to producers and the government. Therefore, there is a net loss in national welfare.
  13. A country that imports steel from a foreign monopoly supplier decides to impose a per-unit tariff on steel imports. How might the effect of this tariff on the domestic price differ from the standard competitive model where the world supply is perfectly elastic?
    Answer: The domestic price will increase, but by less than the full amount of the tariff. In the standard small country model with perfectly competitive world markets, the world supply is perfectly elastic, and the domestic price rises by the full amount of the tariff. However, when the foreign supplier is a monopolist, it faces a downward-sloping demand curve for its exports. The tariff acts like a tax on the monopolist. A monopolist will typically share the burden of a tax with consumers. The monopolist will raise its price, but to maintain sales volume, it will absorb part of the tax itself. Therefore, the domestic price will rise by less than the full amount of the tariff, as the price the monopolist receives (net of the tariff) will fall.
  14. The nation of Autocania produces cars, which requires steel as a key input. Autocania's car market is closed to international trade, but its steel market is open, and it imports steel. If the government imposes a tariff on imported steel, what is the most likely impact on the domestic market for cars?
    Answer: The price of cars will increase, and the quantity sold will decrease. A tariff on imported steel raises the domestic price of steel. Since steel is an input in car production, this increases the cost of manufacturing cars. An increase in input costs causes the supply curve for the final product (cars) to shift to the left (a decrease in supply). In the domestic car market, a leftward shift of the supply curve, with the demand curve unchanged, results in a higher equilibrium price and a lower equilibrium quantity of cars sold.
  15. Suppose a small country imposes an export subsidy on wheat, a good for which it is a net exporter. Which of the following effects will occur in the domestic wheat market?
    Answer: Domestic price of wheat will rise, and total domestic surplus will decrease. An export subsidy is a payment to domestic producers for each unit exported. This incentivizes producers to sell abroad, raising the effective price they receive. The domestic price will rise to match the world price plus the subsidy. The higher domestic price hurts domestic consumers, so consumer surplus falls. It helps domestic producers, so producer surplus rises. However, the government must pay for the subsidy, which represents a cost. The cost of the subsidy to the government is greater than the gain in producer surplus, while consumer surplus has fallen. The result is a net loss in total domestic surplus (deadweight loss).
  16. A government that currently imposes a $20 tariff on an imported good is considering replacing it with a policy that gives a $20 subsidy to each unit of domestic production of that good. Both policies result in the same level of domestic production. How would the subsidy's effect on welfare compare to the tariff's?
    Answer: The subsidy is more efficient because it creates no consumption distortion. A tariff raises the domestic price, causing both a production distortion (inefficient domestic production is encouraged) and a consumption distortion (consumers are discouraged from buying units they value more than the world price). A production subsidy also encourages the same level of inefficient domestic production, so it has the same production distortion loss. However, a production subsidy does not raise the domestic price for consumers; the price remains at the world price. Therefore, the subsidy avoids the consumption distortion deadweight loss. Although the subsidy has a direct cost to the government, its deadweight loss is smaller than that of a tariff that achieves the same production level.
  17. Country Alpha exports textiles and imports machinery. If Alpha's government provides a $5 per unit export subsidy for textiles while simultaneously imposing a $3 per unit tariff on machinery imports, what is the most likely combined effect on Alpha's terms of trade and welfare?
    Answer: Terms of trade worsen and welfare decreases because the export subsidy reduces export prices more than the tariff raises import prices The export subsidy encourages increased textile production and exports, which tends to depress world textile prices (worsening Alpha's terms of trade). The import tariff reduces machinery imports but doesn't directly improve export prices. For a small country, the export subsidy typically worsens terms of trade more than the tariff improves them. Both policies create deadweight losses: the subsidy distorts production toward textiles beyond comparative advantage, while the tariff creates standard import protection inefficiencies. Choice A ignores that export subsidies typically worsen terms of trade. Choice C incorrectly assumes no terms of trade effect. Choice D wrongly suggests terms of trade improve.
  18. The 'small country assumption' in international trade models is critical because it implies that:
    Answer: the country's trade policies have no effect on the world price of goods. The small country assumption means that the country's consumption and production are a negligible fraction of the world total. As a result, any changes in its domestic policy, such as imposing a tariff or quota that alters the amount it imports or exports, are not significant enough to affect the global supply or demand for the good. Therefore, the world price is taken as given and is unaffected by the small country's actions. This simplifies welfare analysis, for instance by ruling out terms-of-trade effects.
  19. A country that exports raw timber voluntarily agrees to limit its exports to a major trading partner. This policy is known as a Voluntary Export Restraint (VER). From the perspective of the importing country, how does the welfare impact of this VER compare to a tariff that would result in the same level of imports?
    Answer: The VER is worse, because the equivalent of tariff revenue is captured by foreign exporters. A VER restricts the quantity of a good that can be imported, just like a quota. This raises the price in the importing country. The difference between the world price and the higher domestic price creates a rent. With a tariff, this rent would be collected by the importing country's government as revenue. With a VER, the exporting country's government or producers manage the restraint, so they are the ones who capture this rent (by selling the limited quantity at the higher price). Therefore, for the importing country, the VER results in a greater national welfare loss than a tariff that restricts imports by the same amount, because the rent is transferred abroad.
  20. The domestic market for a good is described by the demand equation P=150−QDP = 150 - Q_D and the supply equation P=30+2QSP = 30 + 2Q_S. The world price for this good is PW=50P_W = 50. If the government imposes a $10 per-unit tariff on imports, what is the resulting deadweight loss?
    Answer: $75 This is a multi-step calculation. First, find quantities under free trade (at PW=50P_W = 50). Domestic supply: 50=30+2QS⇒QS=1050 = 30 + 2Q_S \Rightarrow Q_S = 10. Domestic demand: 50=150−QD⇒QD=10050 = 150 - Q_D \Rightarrow Q_D = 100. Next, find quantities with the tariff. The new domestic price is PT=50+10=60P_T = 50 + 10 = 60. New domestic supply: 60=30+2QS′⇒QS′=1560 = 30 + 2Q_S' \Rightarrow Q_S' = 15. New domestic demand: 60=150−QD′⇒QD′=9060 = 150 - Q_D' \Rightarrow Q_D' = 90. The deadweight loss consists of two triangles. The production distortion loss is 0.5×(PT−PW)×(QS′−QS)=0.5×10×(15−10)=$250.5 \times (P_T - P_W) \times (Q_S' - Q_S) = 0.5 \times 10 \times (15 - 10) = \$25. The consumption distortion loss is 0.5×(PT−PW)×(QD−QD′)=0.5×10×(100−90)=$500.5 \times (P_T - P_W) \times (Q_D - Q_D') = 0.5 \times 10 \times (100 - 90) = \$50. Total deadweight loss is $25 + $50 = $75\).

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