Albert Tran
30.e. International Trade: Tariffs and Trade
When learning about economics it is easy to start thinking about a market that only lies in one
country. However if we take a closer look at all the products that are commonly used everyday, we find that
the tags and labels will say that these products were made in another country. Utilizing simple tools of
basic economics: supply and demand, market equilibrium, opportunity cost, and producer and consumer
surplus, we can see the benefits of International trade and consequently the effect a tariff has on economic
well being.
International trade revolves around the principle of comparative advantage. Comparative
advantage refers to the opportunity cost a producer has when producing a good. Consider the case of the
popular TV show Gilligan’s Island. Suppose we only consider two workers on the island, Gilligan and
Mary-Anne, and two goods that these two can harvest, fish and bananas. Assuming one can only work
during 12 hours of daylight, in one day, Gilligan needs 2 hours to catch one fish and four hours to get one
unit of bananas. In one day, Mary-Anne needs one hour to catch a fish and one hour to collect one unit of
bananas. At first glance, it appears that the dimwitted Gilligan is too busy falling over himself and is unable
to be as productive as Mary-Anne. One would think that Mary-Anne has no desire to share or trade with
Gilligan since she needs less time to collect either good. Here, Mary-Anne has an absolute advantage in the
production of both goods. However, one must examine the opportunity cost to be able to see the
comparative advantage. Let us take a look at the production of each worker on the island and how trade can
benefit both workers.
Bananas
Mary-Anne
12
Before Trade:
Fish
Mary-Anne
3
Mary-Anne After Trade
Bananas
9
9
Gilligan
2
2
Total
6
10
With Specialization
Fish
3
12
Bananas
Bananas
12
Mary-Anne
0
Gilligan
6
0
Total
6
12
Fish
Gilligan
After Trade, with specialization
Price 1Fish: 0.75 Bananas
Gilligan trades 4 fish to
Mary-Anne for 3 bananas
Fish
Bananas
9
Mary-Anne
4
3
Gilligan
2
3
2
Total
6
12
Gilligan after Trade
2
6
Fish
Fig 30.e.1
As we can see, after specializing and trading based on comparative advantage, both workers are
better off and are at a point beyond each of ther production possiblilty constraints.
Albert Tran
The opportunity cost for Mary-Anne is one fish for one banana. For Gilligan, the opportunity
cost for one fish is half a unit of bananas, and the cost of one banana for Gilligan is 2 units of fish. What
this means, is that for every fish Gilligan goes after, he only forgoes half a unit of bananas. Mary-Anne on
the other hand, has to give up one whole unit of bananas for every fish she catches. Here, Gilligan has the
comparative advantage in fishing. If Gilligan were to trade with Mary-Anne, for a price such as one fish for
0.75 units of bananas, both workers will be better off. Gilligan will get ¾ a banana instead of the ½ he
normally gets for one unit of fish, and Mary-Anne only has to pay ¾ a unit of banana for one fish instead of
the normal one banana for one fish price she pays. Since Mary-Anne has a comparative advantage in
harvesting bananas, and Gilligan has the comparative advantage in harvesting fish, both end up better off in
the end due to the benefits of trade.
Now, after seeing how trade can benefit all parties involved, let us apply this to a country in
international trade. Consider the market for grapes in the nation of Grapeland. First we must assume that
Grapeland is a very small nation with a small economy compared to the rest of the world. This implies that
Grapeland is a price taker in the world economy. That is, Grapeland must take the price of grapes as
dictated by the equilibrium forces in the world economy, meaning Grapeland can import grapes and buy
grapes at the given world price or sell their grapes and export grapes at the world price. Whether Grapeland
will be an importer or exporter of grapes will depend on the world price of grapes in comparison to the
domestic price of grapes. If the domestic price of grapes is less than the world price of grapes, this means
that Grapeland is capable of producing grapes at a lesser cost compared to the rest of the world, meaning
Grapeland has a comparative advantage in producing grapes and will export grapes to the rest of the world.
Once free trade is allowed to occur, equilibrium will shift, since no seller of the good would sell for less
someone a unit of grape for less than the world price when they can sell to the rest of the world for more,
and likewise no buyer of grapes will pay more for grapes when they can go and buy grapes for the world
price. Thus a new equilibrium is established.
P
A
Domestic Supply
World
Price
World Price 1
B
D
P
before
trade
Consumer Surplus
Before
Trade
A+B
After
Trade
A
Change
B
Producer Surplus
C
C+B+D
B+D
A+B+C
A+B+C+D
D
C
Total Surplus
Domestic Demand
Net Export of Good
Qdemanded
Qsupplied
Quantity
Fig 30.e.2
After international trade at the world price, the producers of Grapeland are better off, earning additional surplus of B+D,
while consumers are worse off losing area B. However as a whole, the nation is better off by gaining area D, as trade
raises the economic well being of the nation due to the simple fact that the winners gained more than what the
losers lost.
Likewise, if the domestic price of grapes is higher than the world price, this suggests that
Grapeland produces grapes at a higher cost compared to the rest of the world and would be better off
buying and importing grapes from the rest of the world.
Albert Tran
P
Domestic Supply
Consumer Surplus
Before
Trade
A
After
Trade
A+B+D
Change
B+D
Producer Surplus
C+B
C
B
A+B+C
A+B+C+D
D
A
Price
Before
Trade
B
D
Total Surplus
World
Price
World Price 2
C
Imports
Domestic Demand
Qsupplied
Qdemanded
Quantity
Fig 30.e.3
Similar to the case of exports, here Grapeland an import grapes at a lower price than the domestic price.
Consumers are better off by areas B and D, while producers are worse off by area B. Again, as a nation,
Grapeland is better off since the winners gained more than the losers, totalling a net gain of area D.
After seeing all the benefits and effects of international trade on the small nation of Grapeland, we
see how international trade improves the well being of the economy as a whole. In both the exporting and
importing scenarios, the gains of the winner exceed the losses of the losers, and thus the economy benefits.
However, as in all things in this world, nothing comes for free. In examining the effects of a tariff, a tax on
goods imported into Grapeland, one can see that this will have a great affect on the economy and free trade.
A tariff on imported goods into Grapeland will only matter if Grapeland needs to import grapes. Therefore
we will examine the scenario in which Grapeland is a grape importer.
Domestic Supply
Price
Fig30.e.4
The tariff imposed
by Grapeland reduces the total
quantity imported by the nation
and moves the market closer
A
to that of the equilibrium without
international trade. There is a deadweight loss of areas DF due to the tariff
B
C
E
Tariff
D
F
Imports with
G
tariff
Qs1
Qs2
Qd2
Qd1
Domestic Demand
Quantity
Imports without tariff
Consumer Surplus
Before Tariff
ABCDEF
With Tariff
AB
Change
(CDEF)
Producer Surplus
G
GC
C
Govt Revenue
none
E
E
Total Surplus
ABCDEFG
ABCEG
(DF)
Albert Tran
Figure 30.e.4 illustrates the change in the market for grapes in the nation of Grapeland due to the
effects of a tariff. In the figure, the tariff raises the price of grapes higher than the world price by the
amount of the tariff. The price of steel now, both imported and domestic, is raised by the tariff. The change
in price has an effect on both buyers and sellers of grapes in Grapeland. With the price of grapes now
higher in Grapeland, consumers will want to buy fewer quantities of grapes. The quantity demanded for
grapes will fall from Qd1 to Qd2. For producers of grapes in Grapeland, the tariff raises the price of
imported grapes, allowing the producers of grapes in Grapeland to be able to sell their grapes for a higher
price. This raises the amount of grapes supplied domestically in Grapeland from Qs1 to Qs2. The net result
of the tariff is a reduction in the amount of grapes imported.
In examining the gains and losses due to the tariff, we simply look at the areas and consider
consumer and producer surplus. Prior to the tariff, consumers were able to buy grapes at the world price.
Their consumer surplus therefore totaled areas ABCDEF. Producers prior to the tariff were able to sell at
the world price, and therefore producer surplus was only area G. Since there is no tax on imports, the
government of Grapeland gets no revenue from free trade.
After the tariff is imposed, consumers will demand a lower quantity of grapes. This drops the
consumer surplus to areas AB. Producers of grapes in Grapeland will be able to sell more of their grapes
since the domestic price is now slightly higher, increasing producer surplus to areas GC. The government
now earns revenue due to the tariff. For every unit imported, the government earns the amount of the tariff,
so total revenue gained by the government is the quantity of imports multiplied by the tariff, area E. Total
surplus of Grapeland is now areas ABCEG.
Examining the change in total surplus of Grapeland prior to and during the tariff, we see that total
surplus decreased by areas D and F. Areas D and F represent the deadweight loss in the economy of
Grapeland due to the tariff imposed on imports. This should not be a surprise, since a tariff is essentially a
tax, and like any tax on goods, incentives to produce and consume in the economy is distorted as resources
are not allocated in their most efficient ways. In our example, the deadweight loss can be traced to two
sources. Due to the tariff, producers of Grapes are selling more than they would without the tariff, at a price
higher than the normal world price of grapes. This inefficiency shows an overproduction of grapes in
Grapeland. Similarly for consumers, with the tariff, consumers are buying a smaller quantity of grapes than
they normally would with the normal world price. This shows an under consumption of grapes by
consumers. Together, these two inefficiencies result in a deadweight loss of areas D and F caused by the
tariff.