Import tariffs
Raises the domestic price of an imported good, protects domestic producers, reduces domestic consumption and imports, and generates government revenue.
International trade video lessons
Tariffs and Export Subsidies
These four video lessons examine how import tariffs and export subsidies affect domestic prices, production, consumption, international trade, government revenue or expenditure, the terms of trade, and national welfare. The analysis distinguishes between small countries that take world prices as given and large countries whose policies can influence world prices.
Export subsidy
Raises the return earned from exporting, increases domestic production and exports, reduces domestic consumption, and requires government expenditure.
Country size
Determines whether the trade policy leaves the world price unchanged or creates an additional terms-of-trade effect.
Why distinguish between small and large countries?
Small-country analysis
A small country is a price taker in world markets. Its imports or exports are not large enough to affect the world price. Welfare changes therefore arise from domestic production and consumption distortions and from the government's revenue or expenditure.
Large-country analysis
A large country has enough market power for a change in its imports or exports to affect the price paid to foreign exporters or received from foreign buyers. National welfare then depends on both domestic efficiency effects and a terms-of-trade effect.
Welfare effects of tariffs in a small country
An import tariff raises the domestic price of an imported good above the world price. Domestic producers respond by increasing production, consumers reduce consumption, and the quantity imported declines. The government collects revenue on the imports that continue to enter the country.
Domestic producers gain and the government receives tariff revenue, but consumers lose from the higher price. Because a small country cannot reduce the world price, the loss of consumer surplus exceeds the combined gains to producers and government. The policy therefore creates an unambiguous loss in national welfare in the standard competitive model.
Video: Welfare Analysis of a Tariff in a Small Country — Consumer and Producer Surplus and Deadweight Loss
Lesson summary
- The domestic price rises by the amount of the tariff.
- Domestic production increases.
- Domestic consumption falls.
- Imports decline.
- The government collects tariff revenue.
- Producers gain while consumers lose.
- Production and consumption distortions create deadweight loss.
- There is no terms-of-trade gain because the world price remains unchanged.
National welfare change = producer gain + tariff revenue − consumer loss
The two deadweight-loss areas represent the efficiency cost of producing too much of the protected good domestically and consuming too little of it after the tariff raises its price.
Welfare effects of tariffs in a large country
A large importing country can influence the price received by foreign exporters. When its demand for imports falls after a tariff is imposed, the foreign export price may decline.
The domestic price still rises, but it may rise by less than the full amount of the tariff because foreign exporters absorb part of the policy through a lower export price. This creates a terms-of-trade gain for the importing country.
Video: Large Country Tariff Analysis — Effects on Trade and Welfare
Lesson summary
- The tariff reduces the large country's demand for imports.
- The foreign export price may fall.
- The domestic price rises, but potentially by less than the tariff.
- Domestic producers gain while consumers lose.
- The government collects tariff revenue.
- Domestic production and consumption distortions reduce efficiency.
- The lower foreign export price creates a terms-of-trade gain.
Can a large country gain from tariffs?
In the basic model, national welfare can increase when the terms-of-trade gain exceeds the production and consumption efficiency losses. This result forms the basis of the optimum-tariff argument.
Net welfare effect = terms-of-trade gain − domestic efficiency losses
This theoretical result does not imply that tariffs are generally desirable. Retaliation, policy uncertainty, administrative costs, supply-chain disruption, lobbying and political pressures can diminish or reverse the apparent gain. When trading partners retaliate, all participating countries may become worse off.
Welfare effects of an export subsidy in a small country
An export subsidy pays domestic producers for each unit exported. Producers therefore have an incentive to sell more in foreign markets. The domestic price rises to reflect the higher return available from exporting.
Production and exports increase, while domestic consumption falls. Producers gain from the higher price, but consumers lose and taxpayers must finance the government's subsidy expenditure. Because a small country cannot affect the world price, the policy creates an unambiguous net welfare loss.
Video: Export Subsidy in a Small Country — Welfare Analysis and Deadweight Loss
Lesson summary
- The domestic price rises above the world price.
- Domestic production increases.
- Domestic consumption falls.
- Exports increase.
- Producers gain while consumers lose.
- The government incurs subsidy expenditure.
- Production and consumption distortions generate deadweight loss.
- There is no terms-of-trade effect because the world price remains fixed.
National welfare change = producer gain − consumer loss − subsidy expenditure
Although the subsidy increases exports, an increase in exports is not itself evidence of an improvement in national welfare. Some additional production costs more than its value at the world price, while domestic consumers are displaced by the artificially higher domestic price.
Welfare effects of an export subsidy in a large country
When a large exporting country expands exports through a subsidy, the resulting increase in world supply can reduce the world price of the exported good. Foreign consumers benefit from the lower price, while the exporting country receives less for its exports.
The exporting country consequently experiences both domestic efficiency losses and a deterioration in its terms of trade. Unlike the large-country tariff case, the terms-of-trade effect reinforces rather than offsets the domestic welfare loss.
Video: Export Subsidy in a Large Country — Welfare Loss and Terms-of-Trade Effects
Lesson summary
- The subsidy increases domestic production and exports.
- Domestic consumption declines as the domestic price rises.
- Producers gain while domestic consumers and taxpayers bear costs.
- The increase in exports can lower the world price.
- The exporting country's terms of trade deteriorate.
- Domestic production and consumption distortions reduce welfare.
- The terms-of-trade loss adds to the domestic efficiency loss.
Why is the large-country result important?
The subsidy transfers income toward domestic producers, but part of its benefit leaks abroad through the lower world price. Foreign buyers receive the exported good more cheaply while domestic taxpayers finance the subsidy. An export subsidy can therefore increase exports while reducing the exporting country's national welfare.
Net welfare loss = domestic efficiency losses + terms-of-trade loss
Comparing the four cases
| Feature | Small-country tariff | Large-country tariff | Small-country export subsidy | Large-country export subsidy |
|---|---|---|---|---|
| Domestic price | Rises by the amount of the tariff. | Rises, potentially by less than the tariff. | Rises by the amount of the subsidy. | Rises relative to the price received in world markets. |
| Domestic production | Increases. | Increases. | Increases. | Increases. |
| Domestic consumption | Falls. | Falls. | Falls. | Falls. |
| Trade volume | Imports decline. | Imports decline. | Exports increase. | Exports increase. |
| Government account | Receives tariff revenue. | Receives tariff revenue. | Pays subsidy expenditure. | Pays subsidy expenditure. |
| World-price effect | None. | The foreign export price may fall. | None. | The world price received by domestic exporters may fall. |
| Terms of trade | No change. | May improve. | No change. | Deteriorates. |
| Basic welfare result | National welfare falls. | National welfare may rise or fall. | National welfare falls. | National welfare falls. |
From economic theory to trade policy
These models provide a benchmark for evaluating actual trade policies. In practice, outcomes depend on market concentration, country size, exchange rates, global supply chains, contractual relationships, the ability of firms and consumers to adjust, and the likelihood of retaliation.
A tariff may support producers in one industry while increasing the input costs of downstream firms. An export subsidy may expand the sales of supported producers while imposing costs on taxpayers and domestic consumers. The distribution of gains and losses therefore matters alongside the aggregate welfare result.
Policy analysis must also distinguish between the stated objective of an intervention and its measurable effects. Higher domestic production, fewer imports or more exports do not by themselves establish that a policy has increased national welfare.
Key takeaway: Country size matters because only a large country can influence world prices in the basic model. A small-country tariff and export subsidies in both small and large countries reduce national welfare. A large-country tariff may create a terms-of-trade gain, but retaliation and other real-world costs can eliminate that theoretical advantage.