2.8 International Trade and Public Policy

Why nations trade

Countries trade based on comparative advantage — the ability to produce a good at a lower opportunity cost than another country. Trade lets each country specialize, increasing total output and allowing mutually beneficial exchange. The world price determines whether a country becomes an importer (world price < domestic price) or exporter (world price > domestic price).

Gains and losses from trade

When a country imports, domestic price falls to world price: consumer surplus rises, producer surplus falls, but total surplus increases (net gain). When a country exports, domestic price rises to world price: producer surplus rises, consumer surplus falls, but total surplus increases. Trade creates winners and losers, but overall surplus grows.

Tariffs and quotas

A tariff (tax on imports) or quota (limit on import quantity) raises domestic price toward the pre-trade price, reducing imports. Both create deadweight loss from reduced trade. Tariffs generate government revenue; quotas often create surplus (rents) for license holders instead. Domestic producers gain, consumers lose, and society suffers a net loss in total surplus.

Key terms

Comparative advantage

The ability to produce a good at a lower opportunity cost than another producer, the basis for trade.

World price

The price of a good in the global market, which determines if a country imports or exports.

Tariff

A tax on imported goods that raises domestic price, reduces imports, and generates government revenue.

Import quota

A limit on the quantity of a good that can be imported; raises price and creates rents for license holders.

Deadweight loss from trade restrictions

The loss in total surplus caused by tariffs or quotas reducing trade below the efficient free-trade quantity.

Try an AP-style question

When a country opens to trade and the world price is below domestic equilibrium…

1. both lose
2. producers gain, consumers lose
3. consumers gain, producers lose
4. neither is affected