Chapter 9: Application — International Trade
Who gains and who loses when countries open their borders to trade
Running Example
The Steel Market in Isoland
Mankiw uses a hypothetical country called Isoland to build intuition for international trade. We'll do the same with a steel market — easy to visualize, and steel is genuinely one of the most politically contested traded goods.
Before trade opens, Isoland's domestic supply and demand determine the price. Once Isoland connects to the world market, the relevant price becomes the world price — set by global supply and demand, not domestic forces alone.
Setting 50 − 2Q = 10 + 2Q gives 40 = 4Q, so the no-trade equilibrium
is Q* = 10 tons, P* = $30. Everything in this chapter hinges on how the world price
compares to that $30 benchmark.
Section 1
World Price and the Direction of Trade
The world price is the price of a good in global markets. Once Isoland opens to trade, domestic buyers and sellers can transact at the world price rather than the domestic equilibrium price. There are only two cases:
If world price > domestic price → the country exports (domestic producers can earn more abroad).
If world price < domestic price → the country imports (domestic consumers can buy cheaper abroad).
Case 1: World price = $40 (above $30) → Isoland exports steel
Case 2: World price = $20 (below $30) → Isoland imports steel
Section 2
Winners and Losers from Trade
Trade always increases total surplus — the pie gets bigger. But it also redistributes that surplus between consumers and producers. This redistribution is why trade is politically contentious even though it's economically beneficial in total.
When Isoland exports (world price = $40):
Winners
- Domestic producers — sell more, at a higher price. PS rises from $100 to $225.
- Domestic economy overall — total surplus increases.
Losers
- Domestic consumers — pay the higher world price. CS falls from $100 to $25.
- The gain to producers ($125) exceeds the loss to consumers ($75), so net surplus rises by $50.
When Isoland imports (world price = $20):
Winners
- Domestic consumers — pay a lower price and buy more. CS rises from $100 to $225.
- Domestic economy overall — total surplus increases.
Losers
- Domestic producers — face lower price and sell less. PS falls from $100 to $25.
- The gain to consumers ($125) exceeds the loss to producers ($75), net surplus rises by $50.
Section 2 — Explorer
Free Trade Explorer
Drag the world price line to see how CS, PS, and total surplus change. When the world price equals the domestic equilibrium ($30), there is no trade. Move it up to create exports; down to create imports.
Drag the world price line up or down to change the trade scenario.
Market Values
Section 3
The Effects of a Tariff
A tariff is a tax on imported goods. Suppose Isoland's world price is $20 (imports scenario) and the government imposes a $6 tariff. The tariff raises the effective domestic price from $20 to $26.
Four things happen simultaneously:
- Domestic price rises from $20 to $26
- Domestic quantity supplied increases (producers respond to higher price)
- Domestic quantity demanded decreases (consumers respond to higher price)
- Imports fall (the gap between QD and QS shrinks)
Notice there are two deadweight loss triangles — one on each side of the imports gap. Triangle B is the production inefficiency — tons 5–8 would be imported at $20, but the tariff makes domestic firms produce them at higher cost instead. Triangle D is the consumption inefficiency — tons 12–15 would have been bought at $20, but consumers drop out at the $26 tariff price.
Section 3 — Explorer
Tariff Effects Explorer
Starting from the import scenario (world price = $20), use the slider to add a tariff. Watch the two DWL triangles grow, government revenue appear, and imports shrink.
Tariff Effects
Section 4
Import Quotas and Trade Policy
An import quota limits the quantity of a good that can be imported. It has a similar price effect to a tariff — the domestic price rises — but with one crucial difference.
Think of it this way: with a tariff, anyone can still import — they just pay $6 extra per ton to the government. With a quota, the government says "only 4 tons total can be imported" and hands out import licenses to specific companies, giving them the exclusive right to import.
Those license holders buy steel abroad at $20 and sell it domestically at $26 (since the quota restricts supply enough to push the domestic price up). They pocket the $6 difference on each ton. That $6 × 4 tons = $24 is called quota rent — it's the same money that would have been government revenue under a tariff, but now it goes to private companies instead.
Both policies create the same DWL (B + D). Both raise the domestic price the same amount. But under a tariff, the government collects C. Under a quota, private license holders pocket C. That's why economists generally consider quotas worse — same damage, less public benefit.
If the government auctions import licenses at the market price, the quota becomes equivalent to a tariff — the government captures area C. But licenses are usually given away (a common political outcome), so the domestic economy loses that revenue to private hands, making the quota strictly worse than a tariff.
Section 5
Arguments For and Against Trade Restrictions
Despite the efficiency case for free trade, governments routinely restrict it. Here are the main arguments — and economists' standard counterarguments.
| Argument | Economist's Response |
|---|---|
| Jobs argument — imports destroy domestic jobs | True in the short run, but trade creates jobs in export industries. Restricting imports protects some jobs while destroying others — often at enormous cost per job saved. |
| National security — we need domestic capacity in key industries | This is the strongest argument and the one most economists accept. The question is which industries genuinely qualify — politicians tend to over-apply it. |
| Infant industry — new industries need time to grow before competing globally | In theory valid, but difficult to implement: which infants become adults? Protection tends to become permanent. Better to use direct subsidies, which are more transparent. |
| Unfair competition — foreign governments subsidize their producers | Foreign subsidies are a gift to domestic consumers (cheaper goods). Responding with our own tariffs punishes our consumers to retaliate for a gift. Economists prefer WTO dispute resolution. |
| Terms of trade — a large country can shift prices in its favor | True for large countries, but invites retaliation. Works only if other countries don't respond. The classic "optimal tariff" argument — but trade wars reduce global welfare. |
The benefits of free trade are diffuse (every consumer gains a little) while the costs are concentrated (specific industries lose a lot). Concentrated interests lobby harder than diffuse interests organize. This is a classic example of the political economy of trade policy.
Summary
Key Takeaways
- World price determines trade direction. If world price > domestic equilibrium → exports. If world price < domestic equilibrium → imports.
- Trade increases total surplus but redistributes it. Exporters benefit producers; importers benefit consumers. The winners could compensate the losers and still gain.
- Tariffs raise the domestic price, increase domestic production, reduce imports, generate government revenue, and create two DWL triangles (B and D).
- Import quotas have the same price effect as tariffs but the revenue goes to license holders (quota rent), not the government — often making them worse than tariffs.
- Trade restrictions always reduce total surplus. Even with valid arguments (national security, infant industry), the economic cost is real — it's a policy choice, not a free lunch.
- Trade policy is political. Concentrated producer interests lobby more effectively than diffuse consumer interests, which is why restrictions persist despite economic evidence against them.
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Work through problems on trade direction, tariff effects, and deadweight loss from trade restrictions.
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