Source: Principles of Microeconomics, 8e (Case/Fair), Ch. 4
Difficulty: Intermediate Prerequisites: Supply and demand basics (Chapter 3), equilibrium price and quantity, understanding of how to read two-panel supply-and-demand diagrams.
Tags: international trade, tariffs, import tax, world price, domestic price, imports, exports, free trade, trade policy, supply and demand analysis, U.S. market, world market, oil imports, bell peppers, computer chips, tax revenue, microeconomics chapter 4
This section applies the supply-and-demand framework to international trade. Most introductory economics courses treat trade analysis as one of the first "applied" topics after students learn the basics, and for good reason: it shows how the same demand-and-supply tools you already know can explain real policy debates about tariffs, quotas, and trade agreements. You need to be comfortable reading two-panel diagrams (world market on the left, domestic market on the right) and calculating import quantities from the gap between domestic supply and domestic demand at a given price. This material connects forward to discussions of comparative advantage, trade policy, and welfare effects of tariffs.
When a country trades freely, the domestic price equals the world price, and the country imports the gap between domestic demand and domestic supply at that price. An import tax (tariff) raises the domestic price above the world price, which reduces imports by both shrinking demand and expanding domestic supply. The government collects tax revenue equal to the tax per unit multiplied by the number of units still imported.
World price
The price at which a good is traded on international markets, determined by global supply and demand. In simple terms, this is the going rate for a good if you could buy or sell it anywhere in the world.
Domestic (U.S.) supply and demand
The supply and demand curves specific to a single country's market. These tell you how much domestic producers will supply and domestic consumers will demand at each price.
Imports
The quantity of a good that a country buys from abroad. Calculated as the difference between domestic quantity demanded and domestic quantity supplied at the prevailing domestic price. In simple terms, imports fill the gap between what domestic producers make and what domestic consumers want.
Tariff (import tax)
A tax levied on goods imported into a country. It raises the domestic price above the world price by the amount of the tax. Think of it as a wedge the government drives between the world price and the price domestic consumers pay.
Tax revenue from a tariff
The total revenue the government collects from the import tax. Calculated as the tax per unit multiplied by the number of units imported after the tax is imposed.
The exam will almost certainly include a two-panel diagram. The left panel shows the world market with a world equilibrium price. The right panel shows the U.S. (domestic) market with its own supply and demand curves. The key steps:
Identify the world equilibrium price from the left panel.
On the right panel, draw a horizontal line at that world price.
At the world price, read off the domestic quantity demanded (from the demand curve) and the domestic quantity supplied (from the supply curve).
Imports = quantity demanded minus quantity supplied at the world price.
Under free trade (no tariffs), the domestic price equals the world price. Domestic producers supply what they can at that price, domestic consumers buy what they want, and the shortfall is imported.
Oil example (Figure 4.2):
World price = $10/barrel
At $10, U.S. demand = 8 million barrels/day, U.S. supply = 3 million barrels/day
U.S. imports = 8 - 3 = 5 million barrels/day
Bell pepper example (Figure 4.3):
World price = $0.50/pepper
At $0.50, U.S. demand = 7 million/day, U.S. supply = 4 million/day
U.S. imports = 7 - 4 = 3 million/day
Computer chip example (Figure 4.4):
World price = $20/chip
At $20, U.S. demand = 8 million, U.S. supply = 2 million
U.S. imports = 8 - 2 = 6 million
When the government imposes a tariff, three things happen simultaneously in the domestic market:
Domestic price rises by the amount of the tax (domestic price = world price + tax).
Quantity demanded falls, because domestic consumers face a higher price and buy less.
Quantity supplied domestically rises, because domestic producers receive a higher price and produce more.
Imports shrink from both sides: consumers want less and domestic producers supply more.
Oil example with $2/barrel tariff:
New domestic price = $10 + $2 = $12/barrel
At $12, U.S. demand = 7 million, U.S. supply = 5 million
New imports = 7 - 5 = 2 million barrels/day
Tax revenue = $2 x 2 million = $4 million/day
Bell pepper example with $0.10/pepper tariff:
New domestic price = $0.50 + $0.10 = $0.60/pepper
At $0.60, U.S. demand = 6 million, U.S. supply = 5 million
New imports = 6 - 5 = 1 million/day
Computer chip example with $5/chip tariff:
New domestic price = $20 + $5 = $25/chip
At $25, U.S. demand = 6 million, U.S. supply = 4 million
New imports = 6 - 4 = 2 million
Tax revenue = $5 x 2 million = $10 million
Tax revenue = (tax per unit) x (quantity of imports after the tax)
This is a rectangle on the diagram: the height is the tax per unit, the width is the post-tax import quantity. A common error is to multiply the tax by the pre-tax import quantity instead of the post-tax quantity.
Imports under free trade: Imports = Q_demanded(at world price) - Q_supplied(at world price)
Domestic price with tariff: P_domestic = P_world + tariff
Imports after tariff: Imports_new = Q_demanded(at P_domestic) - Q_supplied(at P_domestic)
Tax revenue: Tax revenue = tariff x Imports_new
Tariffs on imported steel, aluminium, or agricultural products work exactly this way: they raise the domestic price, protect domestic producers (who can now sell more at the higher price), reduce the quantity consumers buy, and shrink imports. The government collects revenue, but domestic consumers pay more. This framework is the basis for evaluating any trade-policy debate.
Students often calculate tax revenue using the pre-tariff import quantity. The tariff reduces imports, so you must use the post-tariff quantity. Read the new quantities off the graph at the new (higher) domestic price.
Students sometimes think the tariff raises the world price. It does not (assuming the country is small relative to the world market). The world price stays the same; only the domestic price rises.
Students occasionally forget that the tariff has two effects on imports: demand falls and domestic supply rises. Both contribute to the reduction in imports.
Some students assume that eliminating a tariff would leave the domestic price unchanged. Removing the tariff drops the domestic price back to the world price, which increases imports.
⚠️ Two-panel trade diagrams appear frequently on exams. Practise reading off quantities at different prices and calculating the import gap.
⚠️ Tax revenue calculations are a favourite exam question. Remember: tax per unit times the post-tariff import quantity, not the pre-tariff quantity.
⚠️ You may be asked what happens when a tariff is imposed starting from free trade. Walk through all three effects: price rises, demand falls, domestic supply rises, imports shrink.
⚠️ You may also be asked the reverse: what happens when all tariffs are eliminated? The domestic price falls to the world price and imports increase.
Fill in the blank: Under free trade, the domestic price of a good equals the ________ price. (world)
True or False: An import tax raises the world price of the good. (False – it raises only the domestic price.)
Fill in the blank: Tax revenue from a tariff equals the tax per unit multiplied by the ________ import quantity. (post-tariff)
True or False: A tariff causes domestic supply to fall. (False – domestic supply rises because domestic producers receive a higher price.)
Fill in the blank: When the U.S. imposes a tariff, imports shrink because demand ________ and domestic supply ________. (falls; rises)
Q: At a world price of $10/barrel, the U.S. demands 8 million barrels and supplies 3 million barrels per day. How many barrels does the U.S. import?
A: 5 million barrels per day (8 - 3 = 5).
Q: If the U.S. imposes a $2/barrel tariff on oil and the world price is $10, what is the new domestic price?
A: $12 per barrel ($10 + $2).
Q: After a $2/barrel tariff, the U.S. demands 7 million barrels and supplies 5 million barrels. What is the daily tax revenue?
A: $4 million per day ($2 x 2 million imports).
Q: If the U.S. eliminates all taxes on imported computer chips and the world price is $20, what happens to the domestic price and imports?
A: The domestic price falls to $20, and imports increase to the gap between quantity demanded and quantity supplied at $20 (6 million in the textbook example).
Q: A $5 tariff on computer chips raises the domestic price to $25. U.S. firms previously supplied 2 million chips at $20. At $25 they supply 4 million. By how much did domestic supply increase?
A: By 2 million chips (4 - 2 = 2).
This material connects to the welfare analysis later in Chapter 4 (consumer surplus, producer surplus, and deadweight loss from tariffs). It also sets the stage for comparative advantage and the gains from trade covered in later chapters. The logic of how taxes create wedges between buyers and sellers reappears in the analysis of domestic excise taxes and tax incidence.
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