KEY POINTS

1. The government of a country can use laws and regulations, called “trade policies,” to affect international trade flows. An import tariff, which is a tax at the border, is the most commonly used trade policy.
2. The rules governing trade policies in most countries are outlined by the General Agreement on Tariffs and Trade (GATT), an international legal convention adopted after World War II to promote increased international trade. Since 1995 the new name for the GATT is the World Trade Organization (WTO).
3. In a small country, the quantity of imports demanded is assumed to be very small compared with the total world market. For this reason, the importer faces a fixed world price. In that case, the price faced by consumers and producers in the importing country will rise by the full amount of the tariff.
4. The use of a tariff by a small importing country always leads to a net loss in welfare. We call that loss the “deadweight loss.”
5. A discriminatory tariff, which is applied against just one exporting country (such as the tariff on tires applied against China), has a higher deadweight loss than an equal tariff applied against all exporters.
6. In a large country, the decrease in imports demanded due to the tariff causes foreign exporters to lower their prices. Consumer and producer prices in the importing country still go up, since these prices include the tariff, but they rise by less than the full amount of the tariff (since the exporter price falls).
7. The use of a tariff for a large country can lead to a net gain in welfare because the price charged by the exporter has fallen; this is a terms-of-trade gain for the importer.
8. The “optimal tariff” is the tariff amount that maximizes welfare for the importer. For a small country, the optimal tariff is zero since any tariff leads to a net loss. For a large country, however, the optimal tariff is positive.
9. The formula for the optimal tariff states that it depends inversely on the foreign export supply elasticity. If the foreign export supply elasticity is high, then the optimal tariff is low, but if the foreign export supply elasticity is low, then the optimal tariff is high.
10. “Import quotas” restrict the quantity of a particular import, thereby increasing the domestic price, increasing domestic production, and creating a benefit for those who are allowed to import the quantity allotted. These benefits are called “quota rents.”
11. Assuming perfectly competitive markets for goods, quotas are similar to tariffs since the restriction in the amount imported leads to a higher domestic price. However, the welfare implications of quotas are different from those of tariffs depending on who earns the quota rents. These rents might be earned by firms in the importing country (if they have the licenses to import the good), or by firms in the exporting country (if the foreign government administers the quota), or by the government in the importing country (if it auctions off the quota licenses). The last case is most similar to a tariff, since the importing government earns the revenue.