Trade and the Global Economy
Trade and the Global Economy
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Countries make more of some goods and buy the rest from abroad. This brings real gains, but also real risks.
Think about the people in your town. A doctor does not grow her own rice, and a rice farmer does not treat patients. Each does one job well and buys everything else. Countries work in the same way.
Specialisation: the concentration by an individual, firm, region or country on producing a limited range of goods or services.
A country that specialises makes more of some goods than it needs and exports the extra. It uses the money it earns to import the goods it no longer makes. So a country can only specialise if it can trade.
Whether specialisation is good for a country depends on the balance between these. A country with many different exports faces much less risk than one that relies on a single product.
Real Example: Tourism is the Maldives' main industry, and money spent by foreign visitors counts as an export of services. Before the pandemic, tourism made up nearly a quarter of the country's output. In 2020 borders closed, only about 555,000 tourists came, two-thirds fewer than in 2019, and the economy shrank by about a third.
Exam Matters: Look for evidence of risk in the case: how much income comes from one export, and whether the country imports essentials. Weigh one benefit against one cost for that country.
A country can be better at making everything and still gain from trade. What matters is what it gives up.
Imagine two countries, Merida and Kalto, that each make grain and cloth. The table shows what each could make if it used all its resources on one good.
Absolute advantage: the ability of a country to produce more of a good than another country, using the same quantity of resources.
Merida can make more of both goods, so it has an absolute advantage in both. Does it still gain from trade? Look at what each country gives up.
Opportunity cost: the next best alternative given up when a choice is made.
Comparative advantage: the ability of a country to produce a good at a lower opportunity cost than another country.
Whenever the two opportunity costs differ, each country has a comparative advantage in one good, so trade can benefit both.
Some tables show the hours one unit takes, not the output. Then the division flips: the good you are costing goes on top.
Real Example: Clothing is about four-fifths of Bangladesh's exports of goods, while Germany's biggest exports are cars and machinery. Germany could sew shirts, but every worker moved into sewing would stop making goods worth far more. So a shirt costs Germany much more in what it gives up.
Exam Matters: Check whether the table gives output or hours, show each division, then say who has the advantage in which good.
When each country makes more of the good it has a comparative advantage in, total output rises.
Merida can make 120 grain or 60 cloth, and Kalto 40 grain or 40 cloth. So Merida has the comparative advantage in grain, and Kalto in cloth.
Why 100 grain and not 120? Making only grain would leave just 40 cloth in total, fewer than the 50 before. So Merida keeps making 10 cloth, which costs it 20 grain.
Now cloth is unchanged and grain rises from 80 to 100. Nobody works harder: each country simply moved towards the good it makes at a lower opportunity cost.
To share the gain, the countries agree how much grain to swap for each cloth: the swap rate, which economists call the terms of trade. It must lie between the two opportunity costs. Below 1 grain per cloth Kalto would rather make its own grain; above 2, Merida would rather make its own cloth.
Say they agree 1.5 grain per cloth, and Kalto swaps 20 cloth for 30 grain. Merida ends with 70 grain and 30 cloth, Kalto with 30 grain and 20 cloth: each has 10 more grain than before. The nearer the rate is to a country's own opportunity cost, the less of the gain it gets.
A country's production possibility frontier (PPF) shows every mix of goods it can make. With a constant opportunity cost it is a straight line: Merida's runs from 120 grain to 60 cloth, Kalto's from 40 grain to 40 cloth. Alone, a country can only consume on or inside its PPF.
After trade, both countries' consumption points lie outside their own PPFs. That is the gain from trade: each consumes more than it could make on its own.
Real Example: Kenya is one of the world's largest exporters of cut roses, mostly to Europe. Near the equator, Kenyan growers have sunshine all year, while Dutch growers need heated greenhouses in winter. Europe gets cheaper flowers, and Kenya earns foreign currency for machinery and fuel.
Exam Matters: Show total output of both goods before and after, then state the difference. On a diagram, draw both straight-line PPFs and mark each country's consumption after trade outside its own frontier.
The theory of comparative advantage rests on simple assumptions. For each one, know what breaks it in the real world.
The Merida and Kalto example is a model. Like every model, it simplifies the real world so that the main idea is easy to see. These simplifications are its assumptions.
A broken assumption does not make the theory wrong. It changes how big the gain from trade is, and who receives it.
Real Example: During the COVID-19 pandemic in 2021, the cost of shipping a container from China to Europe rose to several times its normal level. For cheap, bulky goods such as furniture, the shipping cost became a large part of the price. This shows that the assumption of no transport costs can matter a great deal.
Exam Matters: When you evaluate the theory, pick an assumption that clearly fails in the case, such as workers who cannot move into a new industry. Naming it is not enough: say what breaks it there, and what that does to the gain.
When the assumptions break, the gain from trade shrinks and is shared unevenly. It rarely disappears.
A limitation is what happens to the theory's prediction when an assumption breaks. Go back to Merida and Kalto, whose specialising made 20 more grain, and see how much of it survives.
The theory shows that total output rises, not who receives the extra. Between countries, the swap rate decides the split. Inside a country, profits go to whoever owns the firms, often foreign companies, while workers in shrinking industries can lose their jobs.
Comparative advantage also changes as wages, skills and technology change, so today's gain may not last. The real gain is smaller, less certain and less evenly shared than the model predicts, but it is usually still a gain.
Real Example: After China joined the World Trade Organization in 2001, its exports to the United States grew very quickly. American consumers gained cheaper furniture, toys and electronics. But many US factory towns lost jobs, and research found that many of these workers did not find new jobs quickly.
Exam Matters: Limitations are what you use to evaluate the theory in longer answers. Choose two that fit the case, explain how each one shrinks the gain or changes who gets it, and say which matters more.
The pattern of trade is which goods a country trades and with whom. The volume is how much it trades.
Every country sells some goods abroad and buys others. Which goods it trades, and which countries it trades with, make up its pattern of trade. How much it trades is its volume of trade.
Pattern of trade: the types of goods and services a country exports and imports, and the countries it trades with.
Volume of trade: the total amount of goods and services exported and imported over a period of time.
The two can change separately. A country's exports can double while it sells the same goods to the same partners: the volume changes, but the pattern does not.
A pattern changes when buying from one country becomes cheaper or dearer than buying from another, so buyers switch suppliers. Five forces do this: emerging economies, changes in comparative advantage, trade agreements, exchange rates and protectionism. Explain each the same way: what changed the price, and who switched as a result.
Real Example: For decades Japan was Australia's biggest export market. Since the late 2000s China has taken that place, mainly because Chinese steelmakers buy huge amounts of Australian iron ore. Australia still exports mostly minerals and energy, but its main customer has changed. That is a change in its pattern of trade.
Exam Matters: To explain a change in a pattern of trade, say what changed the price, then how buyers responded.
Emerging economies such as China, India and Vietnam now make, sell and buy far more of the world's goods, often as one link in a longer chain.
Emerging economy: an economy with low or middle income per head that is growing rapidly, industrialising and becoming more open to world trade.
Over the last 30 years, emerging economies' share of world exports has risen from about 24% to about 44%, so the advanced economies' share fell from 76% to 56%. Their exports still grew, because world trade grew so much.
They also change trade as buyers: as incomes rise, they import more raw materials, food and machinery.
Few goods are now made in one country: design, parts and assembly often each happen somewhere different. Emerging economies usually join at simple stages such as assembly, then try to move up.
Global value chain: the stages of producing a good, from design and parts to assembly and sale, spread across different countries.
Value added: the value of a firm's or country's output minus the cost of the goods and services bought in to make it.
Say a phone assembled in Vietnam sells abroad for $200, and its imported parts cost $170. It adds $200 to Vietnam's exports but only $30 of value added, the wages and profits made in Vietnam. Export figures can be far bigger than the income a country earns from them.
Real Example: In the 1990s Vietnam mainly exported rice, crude oil and clothing. Samsung opened its first large phone factory there in 2009, and phones and electronics became Vietnam's biggest exports. Many chips and screens are imported, so much of Vietnam's part of the chain is assembly.
Exam Matters: Link low costs to a rise in exports of a particular good, and rising incomes to a rise in imports. When a case mentions imported parts, say that the value added at home is smaller than the export figure.
Comparative advantage is not fixed. When a country's costs or skills change, the goods it exports and imports can change too.
A country's comparative advantage depends on its opportunity costs. These change over time because of investment, education, new technology, new discoveries of resources and rising wages.
Rivo did not get worse at shirts. It got better at phones, so each shirt now costs it more phones given up. Countries also lose a comparative advantage when others catch up, or when rising wages push labour-intensive work to lower-wage countries.
Real Example: As wages in China rose in the 2010s, some clothing and shoe production moved to lower-wage countries such as Vietnam, Bangladesh and Cambodia. At the same time China moved into more advanced goods, such as electric cars and solar panels, which it now exports in large numbers.
Exam Matters: Name what changed, explain how it changed the opportunity cost, then say which goods the country now exports.
When countries agree to cut trade barriers between themselves, members buy more from each other and less from outsiders.
Trading bloc: a group of countries, usually in the same region, that agree to reduce or remove barriers to trade between themselves.
Bilateral trade agreement: an agreement between two countries to reduce or remove barriers to trade between them.
The number of these agreements has grown quickly since the 1990s. Examples include ASEAN in South-East Asia, the Gulf Cooperation Council and the African Continental Free Trade Area.
Some of this is new trade: the partner's goods replace dearer goods made at home. Some is trade moved away from a country outside the agreement, which may have been the cheaper producer. Which of the two is bigger decides whether members really gain, and it is the main question economists ask about any trading bloc.
The size of the change depends on who joins: opening a large market that was closed before changes far more than a deal between countries that already trade a lot.
Real Example: India and the United Arab Emirates signed a bilateral trade agreement, the Comprehensive Economic Partnership Agreement, in 2022. It removed or cut tariffs on most goods traded between the two countries. Trade between India and the UAE grew strongly in the years that followed.
Exam Matters: Explain in two steps: the agreement makes members' goods cheaper than outsiders', so buyers switch to members. Name which country gains a market and which loses one.
When a country's currency falls in value, its exports become cheaper abroad and its imports become dearer at home.
Exchange rate: the price of one currency in terms of another currency.
A product's price abroad can change even when nothing about the product changes. If the exchange rate moves, foreign buyers pay a different amount in their own currency for the same good.
Depreciation: a fall in the value of a currency against other currencies.
So when a currency depreciates, the country tends to export more and import less, and trade shifts towards its goods. When a currency rises in value, called an appreciation, the opposite happens.
What matters is the relative exchange rate: one currency against another. The size of the effect depends on how sensitive buyers are to price, and whether the change lasts.
Real Example: Between 2021 and 2024 the Japanese yen fell sharply against the US dollar, to its lowest level in more than 30 years. Carmakers such as Toyota reported record profits, helped by the weak yen. But for Japanese families, imported food and fuel became more expensive.
Exam Matters: For the foreign price of an export, multiply the home price by the rate. For the home price of an import, divide its foreign price by the rate. Show each step.
When governments raise or lower barriers to imports, buyers switch suppliers and the pattern of trade changes.
Protectionism: government policies that restrict imports in order to protect domestic producers from foreign competition.
Protection can take the form of taxes on imports (tariffs), limits on the amount that can be imported (quotas) or rules that make importing harder. If a government raises a tariff, the imported good becomes dearer and some buyers switch to goods made at home. If it lowers a tariff, buyers switch the other way.
A tariff on goods from only one country can also push buyers to a third country that the tariff does not cover, so the imports may not come home at all.
Since 1950, tariffs have fallen a lot under international agreements, and world trade has grown faster than world output. Recently some countries have raised them again. In August 2025 the United States put a 20% tariff on most goods from Vietnam, and 40% on goods judged to have been routed through Vietnam to dodge a higher tariff. The rates have changed several times since.
Real Example: In 2018 and 2019 the USA put tariffs on many goods from China. US imports from China fell, but imports from Vietnam and Mexico rose sharply. In 2023 Mexico overtook China as the largest source of goods imported into the USA.
Exam Matters: Say whose goods become dearer and where buyers switch to: home producers or a third country. Then say whose exports rise and whose fall.
Trade between countries changes in how much is traded, who trades with whom and which goods are traded. Each change has a reason.
Trade flow: the movement of goods and services from one country to another, measured by its value, direction and type of goods.
A trade flow can change in three ways: how much is traded, which countries trade with each other, and which goods are traded. To describe a change, you often need to work out values from shares.
A share and a value can move in different directions. If total exports grow fast enough, a good's share can fall while its value still rises. Always check the total before you decide whether a flow rose or fell.
Flows change for the same reasons as patterns: changing costs, trade agreements, exchange rates and protection. They also change suddenly after a shock. A war, sanctions or a pandemic can cut off supplies, so buyers must find new suppliers within months.
Real Example: Before 2022 much of Russia's oil was sold to Europe. After Russia invaded Ukraine, the European Union banned most imports of Russian oil by sea. Russia sold its oil at a discount to other buyers instead, and India and China became its largest customers. The flow of Russian oil changed direction within about a year.
Exam Matters: Work out each value from the shares and show the calculation, then give a reason for the change from the evidence.
The terms of trade compare the prices a country gets for its exports with the prices it pays for its imports.
Imagine a country that sells copper and uses the money to buy fuel and machinery. In some years a tonne of copper pays for a lot of imports. In other years it pays for much less.
The copper has not changed. Its price has changed compared with the prices of what the country buys. Economists measure this with the terms of trade.
Economists track these prices with an index: a number showing how prices have changed since a base year, set at 100.
Terms of trade: the rate at which a country's exports exchange for its imports, measured by comparing export prices with import prices.
These words say which way the index moved. On their own, they do not tell you whether the country is better off.
Real Example: Bangladesh earns most of its export income from clothing, and it is one of the world's largest buyers of imported cotton. When world cotton prices rise, the price of what Bangladesh buys goes up. Its terms of trade can worsen even in a year when its garment factories are busier than ever.
Exam Matters: Say that the terms of trade compare export prices with import prices, as an index.
To calculate the terms of trade, divide the export price index by the import price index and multiply by 100.
A country trades thousands of goods, so economists combine their prices into index numbers. A base year is given the value 100, and later years are compared with it.
Index number: a number that shows how a value has changed compared with a base year, which is given the value 100.
An export price index of 120 means export prices are, on average, 20% higher than in the base year. In the base year both indices are 100, so the terms of trade are 100 too.
Notice that both prices rose. The terms of trade improved because export prices rose faster than import prices. A result below 100 would mean they had deteriorated.
Real Example: Australia's statistics office publishes a terms of trade figure every quarter. It builds an export price index and an import price index from thousands of prices, then divides one by the other and multiplies by 100, the same method you have just used. For a big commodity exporter like Australia, the figure swings with the world prices of iron ore and coal.
Exam Matters: Write the formula, show the division, give the answer to one decimal place, then say whether the terms of trade improved or deteriorated.
If prices rise faster at home than in trading partners, export prices outpace import prices, and the terms of trade improve.
Inflation is a general rise in prices. When prices rise inside a country, the goods it sells abroad cost more. When prices rise in the countries it trades with, the goods it buys from them cost more.
So what matters is relative inflation: inflation at home compared with inflation abroad.
If inflation is the same at home and abroad, both indices rise together. The terms of trade do not change, however high inflation is.
Real Example: In the early 2020s, inflation in Turkey was far higher than in its European trading partners. But over the same years the Turkish lira lost much of its value, so each euro cost many more lira. That made imports dearer in lira, which pushed Turkey's import price index up and could cancel out the improvement that high inflation would otherwise bring.
Exam Matters: To explain this factor, use two steps. First, higher inflation at home than abroad raises export prices faster than import prices. Then, the export price index rises relative to the import price index, so the terms of trade improve.
When productivity grows faster at home than abroad, export prices fall relative to import prices, so the terms of trade deteriorate.
Productivity: output per unit of input per period of time, for example output per worker per hour.
When workers and machines produce more in the same time, the cost of making each unit falls. Competition between firms passes at least part of that saving on to buyers as lower prices.
Here a deterioration is usually good news. The country's goods are cheaper than before, so foreign buyers are likely to buy more of them.
A deterioration can also come from a fall in the world price of the country's main export. The index moves the same way, but the country has not become more efficient, and it earns less for the same work.
Real Example: Over the 2000s and 2010s, factories in China, South Korea and elsewhere in East Asia became far more productive at making electronics. The prices of goods such as televisions and laptops fell year after year. Yet the countries making them sold far more of these goods and earned more from them.
Exam Matters: When you explain this factor, show every link: productivity rises, cost per unit falls, export prices fall relative to import prices, and the terms of trade deteriorate. Going straight from "productivity rose" to "the terms of trade fell" leaves out the reasoning.
If labour costs per unit rise faster at home than abroad, export prices rise relative to import prices, and the terms of trade improve.
Wages are a large part of the cost of making most goods. If wages in a country rise faster than in the countries it trades with, its firms face higher costs. They pass some of this on as higher export prices, so the terms of trade improve.
But higher wages do not always mean higher costs. What matters is the labour cost of each unit produced. If productivity rises as fast as wages, that cost does not change.
Unit labour cost: the average cost of labour for each unit of output produced.
Real Example: Wages in China's coastal factories rose quickly in the 2010s. Many clothing and shoe makers moved some of their production to countries with lower wages, such as Vietnam and Bangladesh. Higher labour costs can raise a country's export prices, but they can also send orders to cheaper rivals.
Exam Matters: If you are given wages and output, work out the labour cost per unit before saying anything about prices. Then explain the effect on export prices and on the terms of trade as separate steps.
A fall in a country's exchange rate usually worsens its terms of trade. A rise usually improves them.
The exchange rate is the price of one currency in terms of another. When it changes, the prices of exports and imports change, even if no firm changes its price list.
Depreciation: a fall in the value of a currency against other currencies.
Appreciation: a rise in the value of a currency against other currencies.
Suppose a country's currency depreciates. Its firms still charge the same in their own currency, so its export price index does not change. But imports now cost more in the home currency, so the import price index rises and the terms of trade deteriorate.
When the currency appreciates, imports become cheaper in the home currency. The import price index falls, so the terms of trade improve.
When you calculate, measure both indices in the same currency. Measuring exports in one currency and imports in another counts the same change twice.
Real Example: During its economic crisis in 2022, Sri Lanka's rupee lost a large part of its value against the US dollar within a few months. Fuel, medicines and many foods had to be imported, and they suddenly cost far more in rupees. With too little foreign currency to pay for them, the country faced long queues for fuel.
Exam Matters: Trace both effects: what happens to export prices and what happens to import prices, measured in the same currency. Keep the effect on the terms of trade separate from the effect on how much the country sells.
World demand and supply set the prices of many traded goods. A country that relies on one commodity has very unstable terms of trade.
Oil, copper, coffee and wheat are primary commodities. Their prices are set on world markets by global demand and supply. A single country usually cannot control them: it is a price-taker, and sells at whatever the world price is.
Primary commodities: raw materials and foodstuffs, such as oil, metals and crops, produced by the primary sector and traded on world markets.
If the world price of a country's main export falls, its export price index falls and its terms of trade deteriorate. If the world price of something it imports rises, such as oil, its import price index rises. Its terms of trade deteriorate in that case too.
A country that relies on one commodity for most of its exports sees its terms of trade swing whenever that price moves. A country that sells many different goods is steadier, because a fall in one price has little effect on the average. This is one reason governments try to diversify their exports.
Some economists argue that, over long periods, commodity prices tend to rise more slowly than the prices of manufactured goods. This is the Prebisch–Singer hypothesis. If it is right, countries that export commodities and import manufactured goods will see their terms of trade slowly deteriorate.
Real Example: Oil makes up the great majority of Nigeria's exports. When the world oil price more than halved between 2014 and 2016, Nigeria's terms of trade deteriorated sharply. As a price-taker, it could not make up for this by selling more: its sales depend on what its wells and pipelines can produce.
Exam Matters: Use the extract's evidence of dependence on one commodity, explain how its world price moves the export price index, and say whether other exports soften the effect.
When export prices rise, price elasticity of demand decides what happens to export revenue, unless world demand has risen.
Export revenue is the export price times the number of units sold. When export prices rise, each unit earns more, but foreign buyers may buy fewer.
Price elasticity of demand (PED): the responsiveness of the quantity demanded of a good to a change in its price.
It also works the other way. If export prices fall and demand is price elastic, export revenue rises even though the terms of trade deteriorate.
All of this assumes world demand stayed the same, so buyers moved along their demand curve. Sometimes prices rise because world demand for the exports has increased: the demand curve shifts right.
Then buyers want more at every price, so price and quantity rise together. The terms of trade improve and export revenue goes up.
Real Example: Around 2010 and 2011, China's booming steel industry needed ever more iron ore, so world demand and prices rose. Australia's terms of trade hit a record high in 2011, yet it also shipped about 10% more iron ore that year. So its export revenue rose.
Exam Matters: Say which elasticity case applies, and why, using evidence from the case.
The terms of trade decide how many imports each export buys, and export revenue feeds aggregate demand, so both shape living standards.
People in every country use imported fuel, food, phones and medicines. The terms of trade tell you how many imports each unit of exports buys.
Standard of living: the level of material well-being of people in a country, often measured by real income per head.
Take Sarova, the imaginary country, with export prices at 120 and import prices at 110. Each unit of its exports now buys 120 ÷ 110 = 1.09 units of imports, about 9% more. But if its buyers cut their orders by 30%, it can afford fewer imports in total.
A deterioration works the other way. It hits hardest in countries that must import essentials such as fuel and food.
Exports are a component of aggregate demand (AD), total spending on a country's output: AD = C + I + G + (X − M). If export revenue falls, AD shifts left, so real output falls and export firms cut jobs.
The fall spreads. Export workers, their suppliers and a government that taxes them all spend less, so other firms sell less too. Real GDP falls by more than the first fall in exports. This is the multiplier.
Multiplier: the process by which an initial change in aggregate demand leads to a larger final change in real national income.
A rise in export revenue works the other way: AD shifts right.
Real Example: Copper makes up about half of Chile's exports. When copper prices were high, its government saved part of the extra earnings in its Economic and Social Stabilization Fund. After copper prices crashed in late 2008, it drew about $9 billion from the fund in 2009 to keep up its spending.
Exam Matters: Give both sides, then link export revenue to AD and the multiplier.
The balance of trade depends on values, not just prices. An improvement in the terms of trade can still leave a trade deficit.
Balance of trade: the difference between the value of a country's exports and the value of its imports.
A value is price times quantity. The terms of trade only tell you about prices, so on their own they cannot tell you what happens to the balance.
A deterioration can do the opposite. If export prices fall and demand for exports is price elastic, export revenue rises and the balance of trade can improve.
Real Example: India imports most of the oil it uses. When the world oil price more than halved between 2014 and 2016, India's terms of trade improved, its oil import bill fell sharply and its trade deficit narrowed. This improvement came from cheaper imports, so it helped the balance of trade.
Exam Matters: Link the terms of trade to the balance of trade through price elasticity of demand. Show each step: prices, quantity sold, export revenue, then the balance of trade.
Whether a change in the terms of trade is good or bad depends on why it happened and how responsive demand is.
An improvement is not automatically good news, and a deterioration is not automatically bad news. The two words only say which way the index moved. To judge a change, ask two questions.
Time matters too. In the short run buyers find it hard to switch supplier, so demand is less elastic. Over a longer period they find alternatives, so a price rise that raises revenue this year can lose customers later.
Real Example: In 2010 China cut its exports of rare earth metals, and their world prices jumped. At first, buyers in Japan and elsewhere had few alternatives. Within a few years they found other suppliers, recycled more and used less, and prices fell back.
Exam Matters: In an evaluate question, reach a judgement that depends on the case: the cause of the change, how price elastic demand is, and how long the change is likely to last.
The WTO helps countries agree to lower their trade barriers together, and then makes sure they keep those promises.
Every country puts some barriers on imports, such as tariffs and quotas. If all countries lowered their barriers together, they would all gain from more trade. But no country wants to open its market on its own. So countries negotiate together.
Trade liberalisation: the reduction or removal of barriers to trade between countries, such as tariffs and quotas.
World Trade Organization (WTO): the international organisation that sets the rules for trade between its member countries, provides a place to negotiate lower trade barriers and settles trade disputes between members.
When a country agrees a tariff cut, it writes down a maximum rate, called a bound rate. It may charge less than this, but never more. This stops a government cutting a tariff one year and raising it again the next.
Real Example: China joined the WTO in 2001, after about 15 years of talks. To join, it agreed to cut its tariffs and to let foreign firms into markets such as banking and telecoms. In return, its exports faced the same low tariffs as other members' exports. China's exports grew very quickly in the years that followed.
Exam Matters: If you are asked to explain the role of the WTO, do not just write that it "promotes free trade". Explain how: members negotiate tariff cuts, the cuts are bound, and a member that breaks them can face a complaint. Make each step lead to the next.
Two WTO rules stop members treating some countries' goods worse than others. A dispute system makes members follow them.
Imagine a country cuts its tariff on rice for one member only. Rice from every other member is now at a disadvantage. The WTO's first rule stops this.
Most-favoured nation (MFN) principle: the WTO rule that a trade advantage, such as a lower tariff, given to one country must be given to all WTO members.
National treatment: the WTO rule that imported goods, once they have entered a country, must be treated no less favourably than the same goods made at home.
Without this second rule, a country could cut its tariff on foreign cars to zero and then put a special sales tax on foreign cars only. The tariff cut would mean nothing.
The system has a weakness. Since December 2019 the WTO's appeal body has not been able to hear cases, because the United States has blocked new judges. A member that loses can appeal, and no final decision is reached.
Real Example: The WTO found that both the EU and the United States had given illegal subsidies to their aircraft makers, Airbus and Boeing. In 2019 and 2020 it allowed each side to put tariffs on billions of dollars of the other's goods. In 2021 the two sides agreed to suspend these tariffs.
Exam Matters: If you explain how the WTO supports free trade, use both rules together. Most-favoured nation spreads each tariff cut to every member. National treatment stops a country undoing a tariff cut with an extra tax on imports.
A WTO deal needs every member to agree, which has become very hard. Many countries now make smaller trade deals instead.
A round of WTO talks ends in one big package, and every member must agree to it. This worked when there were fewer members with similar aims. Today the WTO has more than 160 members, from the richest countries to the poorest, and they want different things.
Farm trade shows the problem. Many poorer countries want rich countries to cut the subsidies and tariffs that protect their farmers. Many rich countries refuse. The Doha Round began in 2001 and has never been finished, mainly for this reason. So countries have turned to smaller deals.
Bilateral trade agreement: an agreement between two countries to reduce the barriers to trade between them.
A regional group of countries that remove barriers between themselves is called a trading bloc. These deals are quicker to agree, because they only include countries that want the same things.
The rules themselves are also under strain. In 2025 the United States set different tariff rates for different countries on the same goods, which goes against most-favoured nation. The WTO estimated that the share of world trade on most-favoured-nation terms fell from about 80% to about 74% in early 2025.
Real Example: Smaller deals have kept moving. RCEP, a trade deal between 15 Asia-Pacific countries including China, Japan and South Korea, came into force in 2022. Narrow deals are still possible inside the WTO too: in 2013 members agreed the Trade Facilitation Agreement, which cuts paperwork and delays at borders.
Exam Matters: If you are asked about the limits of the WTO, explain why agreement is hard: many members, different interests, and everyone must agree. Then explain what followed: bilateral deals and trading blocs.
A trading bloc gives its members lower tariffs than everyone else, which goes against the WTO's most-favoured nation rule.
Look at one good and two exporters. Before a bloc forms, a country charges 12% on the good from both of them. After the bloc forms, the exporter inside the bloc pays 0%, while the exporter outside still pays 12%.
The outsider's tariff has not changed, but it now loses sales to its rival. Charging members different rates is exactly what the most-favoured nation rule forbids. The WTO allows blocs only as a special exception: a bloc must remove barriers on almost all trade between its members, and must not, on the whole, raise its barriers against outsiders.
Some economists disagree. They argue that blocs can be building blocks for free trade, because members get used to open competition and later agree wider deals.
Real Example: In the "banana wars", the EU charged lower tariffs on bananas from its former colonies in Africa, the Caribbean and the Pacific than on bananas from Latin America. After complaints from Latin American countries and the United States, the WTO ruled against the EU several times. The dispute was settled in 2009, when the EU agreed to cut its tariff on Latin American bananas in stages.
Exam Matters: In a question on trading blocs and the WTO, give both sides. Blocs lower barriers between members, which moves the world towards freer trade. But they treat outsiders worse, which breaks the WTO's main rule.
There are four types of trading bloc. Each type keeps everything from the type before it and adds one more feature.
Trading bloc: a group of countries that agree to reduce or remove barriers to trade between themselves, usually while keeping barriers against non-members.
Imagine a Kenyan firm that sells packaged tea to shops in Uganda. Watch what changes as the two countries join more closely.
Each type keeps everything from the one before and adds one feature. Each step also takes a policy away: first its own tariffs on outsiders, then control of who may come to work, then its own interest rate.
Real Example: Real blocs sit at different levels. ASEAN in South-East Asia is a free-trade area. The East African Community, which includes Kenya, Uganda and Tanzania, became a customs union in 2005 and a common market in 2010, and plans a single currency by 2031. The EU is a common market, and the euro countries form an economic and monetary union.
Exam Matters: If you are asked to define a type of bloc, give the feature that makes it different from the type before it, such as the common external tariff for a customs union.
In a free-trade area, members trade without tariffs between them, but each member keeps its own tariffs on the rest of the world.
Free-trade area: a trading bloc in which members remove tariffs and quotas on trade between themselves, but each member keeps its own barriers against non-members.
This is the easiest type of bloc to agree, because members give up very little. Each country still decides its own trade policy towards the rest of the world.
But it creates a loophole. Suppose one member charges 4% on a good from outside the bloc and another member charges 15%. An outside exporter could send the good into the low-tariff member, pay 4%, and then move it tariff-free into the high-tariff member.
Rules of origin: rules that decide which country a product comes from, and so whether it can be traded tariff-free between members of a free-trade area.
A typical rule says that a set share of the good's value, such as 40%, must be added inside the bloc. The firm works out how much of the price comes from parts and work inside the bloc, and proves it with paperwork on every shipment.
This paperwork costs time and money, so it is a cost of trading in a free-trade area. Some small firms find it cheaper to pay the tariff instead.
Real Example: ASEAN is a free-trade area. For most goods to cross between members tariff-free, at least 40% of their value must come from ASEAN countries. Materials from any member count, so a Thai factory can use Malaysian parts and still qualify.
Exam Matters: If you are asked how a free-trade area differs from a customs union, start with the tariff on outsiders: each member sets its own, instead of one common rate. Then explain why that means rules of origin.
A customs union is a free-trade area in which all members charge the same tariff on imports from outside.
Customs union: a free-trade area in which members also charge a common external tariff on imports from non-members.
Common external tariff: a single tariff rate that every member of a customs union charges on a good imported from outside the union.
Once every member charges the same tariff on outsiders, it does not matter which member a good enters through. The loophole of a free-trade area closes, so firms no longer need to prove where goods were made to move them between members.
The cost is independence. A member can no longer set its own tariffs on outsiders, or sign its own trade deals with other countries, because these would undercut the common tariff. Instead the union negotiates as one group, which gives it more bargaining power than a small country alone.
This works in reverse too. When the UK left the EU's customs union at the start of 2021, it won back the right to set its own tariffs and sign its own deals. In December 2024 it joined CPTPP, a trade group around the Pacific, which it could not have done inside the customs union.
Real Example: The Gulf Cooperation Council (GCC) set up a customs union in 2003, with a common external tariff of 5% on most imports. A good from outside pays the same duty whether it arrives in Dubai, Doha or Dammam. In East Africa, Kenya, Uganda, Tanzania and the other members of the East African Community also share a common external tariff.
Exam Matters: The common external tariff is what defines a customs union, so name it in any definition. In an evaluate answer, weigh less paperwork and more bargaining power against the loss of an independent trade policy.
A common market is a customs union in which workers and capital, not just goods, can move freely between members.
Common market: a customs union in which there is also free movement of factors of production, such as labour and capital, between members.
In a customs union, goods cross borders freely, but people and money may not. A nurse in one member may still need a work permit to take a job in another. A common market removes these limits.
Both help resources move to where they produce the most, so total output in the bloc can rise. The gains do not fall evenly, though: it matters which way the workers and the money move.
Real Example: Since 2008 the Gulf Cooperation Council has had a common market. Citizens of the six member countries have the right to live, work and invest in any of them. This applies only to Gulf citizens, not to the many foreign workers in the region, so free movement can be limited to some groups of people.
Exam Matters: Use the phrase "free movement of factors of production" when you define a common market, and give labour and capital as examples. If you are asked about its effects, explain both the gain in output and who wins and who loses.
In an economic and monetary union, members share one currency and one interest rate: cheaper trade, but less control.
Economic and monetary union: a common market in which members also share a single currency and a single monetary policy, and coordinate their other economic policies.
Take a Kenyan firm selling tea to Uganda. With one currency, it pays no bank to change money, and an exchange-rate move cannot ruin a price agreed today. Prices on both sides are in the same money, so buyers compare them easily and firms compete harder.
The cost is control. One central bank sets one interest rate for every member, which may be too high for a member in recession. It cannot let its own currency fall to make exports cheaper, so its firms must hold down wages and prices instead. That is slow, and unemployment can rise.
Fixed (pegged) exchange rate: an exchange rate that the government or central bank holds at a set value against another currency.
Saudi Arabia, for example, has fixed its riyal at 3.75 to the US dollar since 1986. A peg brings some of the gains of a shared currency, with little exchange-rate risk against the dollar. It brings some of the cost too: to hold the peg, the central bank must keep its interest rate close to the US rate.
Real Example: Greece uses the euro, so the European Central Bank sets its interest rate. In its deep crisis after 2009, Greece could not cut its own interest rate or let its own currency fall. It cut wages and government spending instead, and unemployment rose very high.
Exam Matters: In an evaluate question on a monetary union, set cheaper trade against the loss of your own interest rate and exchange rate. Then judge which matters more: how alike are the economies, and is the currency already pegged?
Joining a bloc can let a country buy from a cheaper producer in another member, instead of making the good expensively at home.
Trade creation: the replacement of higher-cost domestic production by lower-cost imports from another member of a trading bloc.
Take one good. It costs $100 to make at home, $80 in a partner country and $70 outside the bloc. Before joining, the country charges 50% on all imports.
Before joining, the home producer is cheapest at $100. After joining, the partner sells at $80 and wins the market. The country now gets the good for $80 instead of using $100 of its own resources: a real saving of $20 on each unit.
On a supply and demand diagram, the price falls from the world price plus the tariff to the partner's price. Home firms make less, because their dearer units are now imported, and buyers buy more. These two changes are the two triangles of trade creation.
Static gains: the one-off gains when a bloc changes who supplies each good, such as trade creation.
Dynamic gains: the gains that build up over time as firms grow and change, such as economies of scale, more competition and more investment.
Real Example: The African Continental Free Trade Area began trading in 2021 and covers almost all of Africa. Tariffs have long held back trade between African countries. Supporters hope goods now made at high cost at home will come more cheaply from a neighbour.
Exam Matters: When you explain trade creation, name the resource saving: where production moves from and to. Call it a static gain, so you can set the dynamic gains beside it when you evaluate.
Joining a bloc can also make a country switch from a cheaper supplier outside the bloc to a dearer one inside it.
Trade diversion: the switch from lower-cost imports from outside a trading bloc to higher-cost imports from a member, caused by the tariff that non-members still pay.
Keep the same costs: $100 at home, $80 in the partner and $70 outside. This time, the country's tariff before joining is only 20%.
Before joining, buyers choose the outsider at $84. Only $70 of this pays for the good. The other $14 is tariff, which goes to the country's own government, so the real cost to the country is $70.
After joining, the partner's price of $80 beats the outsider. Buyers pay $4 less, but the government loses the $14 of tariff. The country now gives up $80 for each unit instead of $70, so its real cost rises by $10 and it is worse off.
On a supply and demand diagram of a customs union, trade diversion is a rectangle: the goods once imported from the outsider, each now costing the gap between the partner's price and the world price. Joining helps only if the trade-creation triangles are bigger.
Real Example: After NAFTA began in 1994, the United States bought more clothing from Mexico, which paid no tariff, and less from some Asian producers, which still did. Some economists see part of this as trade diversion, because some of those Asian producers were cheaper.
Exam Matters: Whether joining helps depends on whether trade creation outweighs trade diversion. In an evaluate question, explain both, then say what the balance depends on, such as the tariff before joining.
Joining a bloc usually lowers prices, because tariffs between members go and firms face more competition. Some prices can rise.
When tariffs between members are removed, goods from partner countries become cheaper. Consumers pay less, and firms that buy parts and materials from partners see their costs fall.
There is a second effect. Home firms now compete with firms from every member. To keep their customers, they must cut costs and prices or improve their products. Because it keeps working year after year, this is a dynamic gain.
But some prices can rise. If the common external tariff is higher than the tariff a country charged before joining, goods from outside the bloc become more expensive.
Real Example: Since 2017, people from EU countries have paid their home prices for calls and mobile data when they travel to other EU countries. Before this, extra roaming charges often made using a phone abroad expensive. It shows that a bloc can lower prices through shared rules, not only by removing tariffs.
Exam Matters: If you calculate a price change, show each step of your working, including the division. Then explain who gains: consumers pay less, and firms that buy inputs from partners have lower costs.
A bloc gives firms a bigger market. Producing more lets them spread their fixed costs and cut the average cost of each unit.
Economies of scale: the fall in long-run average cost that happens when a firm increases the scale of its output.
Before joining, a firm may sell only in its home market. Inside a bloc, it can sell to every member without tariffs, so its market may become several times larger.
Here output rises four times and average cost falls by $10, which is 20%. The firm can pass some of this on as lower prices, or use it to compete better outside the bloc. This is a dynamic gain: it builds up as firms grow, rather than coming once when tariffs fall.
The gain only comes if firms can treat the bloc as one market. Different product rules, paperwork or currencies in each member make this harder.
Real Example: Thailand has become a major centre for making cars and pick-up trucks, sometimes called the "Detroit of Asia". Car makers such as Toyota build pick-ups there for buyers across South-East Asia and beyond. Tariff-free trade between ASEAN members means one large plant can serve several countries instead of one.
Exam Matters: When you analyse economies of scale from joining a bloc, build the chain: bigger market, higher output, fixed costs spread, lower average cost, lower prices. Then say what could stop it, such as different rules in each member.
Every sale to another country carries extra costs, such as changing money and filling in forms. Deeper blocs remove more of them.
Transaction costs: the costs of making an exchange, other than the price of the good itself, such as changing currency, paperwork and delays at borders.
Selling abroad costs more than selling at home. A firm may pay a bank to change currency, fill in customs forms and wait at the border. It also takes the risk that the exchange rate moves before it is paid.
Each cost looks small, but they add up. A firm that sells $25 million a year to another country and loses 2% to transaction costs pays $0.5 million, every year.
How much a bloc saves depends on how deep it goes. Fewer checks at internal borders save time, and a single currency removes the cost of changing money. A free-trade area can even add a cost: the paperwork to prove where goods were made.
Real Example: ASEAN members have linked their customs systems through the ASEAN Single Window. Certificates showing where a good was made can be sent electronically instead of on paper. This cuts delays at borders even though the members do not share a currency.
Exam Matters: Link transaction costs to the type of bloc. A free-trade area can add paperwork through rules of origin, while a monetary union removes the cost of changing currency and exchange-rate risk. This shows you understand how the types differ.
In a common market, workers and capital move to where they earn most. The bloc gains overall, but not every member gains equally.
When workers can take jobs in any member, many move to where wages are higher. Doctors, nurses and engineers can earn far more in a richer member, and no work permit stops them.
Capital moves too. A firm can build its factory in the member where land and labour cost least, and savers can put money wherever the return is highest. The poorer member may gain jobs and machines, while the richer one gains cheaper goods.
For the bloc as a whole, output rises, because workers and capital are used where they are most productive. But the gains and losses fall on different members.
Real Example: Since Romania joined the EU in 2007, many of its doctors have moved to richer members such as Germany and France, where pay is much higher. Patients in those countries benefit. Romania, which paid for their training, has faced shortages of doctors, especially in rural areas.
Exam Matters: In a discuss or evaluate question, first explain the gain for the bloc: labour and capital move to where they are most productive. Then explain who loses, and judge whether the gains outweigh those costs.
Governments sometimes protect a new industry until it can compete, or an old industry while it shrinks slowly.
Restricting imports to shield domestic producers from foreign competition is called protectionism. Two of the reasons governments give for it depend on how old an industry is.
Protectionism: government policies that restrict international trade in order to protect domestic producers from foreign competition.
A new industry is small, so its costs are high, while established foreign rivals produce on a large scale. Protection gives it time to grow and cut its costs through economies of scale.
Infant industry: a new industry that is not yet large enough to benefit from economies of scale, and so cannot yet compete with established foreign producers.
Suppose a new industry's cost per unit starts at $90, while the world price is $50. As its total output grows, its cost per unit falls. After 80 units in total it matches the world price, and protection should end there.
It has worked when protection came with conditions. South Korea shielded Hyundai and Kia from imported cars for decades, but pushed them to export, so they had to compete abroad.
A geriatric industry is an old industry that can no longer compete. Protection does not save it, but it slows the decline, so workers and towns have time to retrain and find new work.
Geriatric industry: an industry in long-term decline that can no longer compete with foreign producers; it is also called a sunset industry.
Both arguments need protection to be temporary. The risk is that it never ends, because a protected firm has less pressure to cut its costs.
Real Example: Indonesia has much of the world's nickel ore, used in steel and car batteries. It banned exports of the raw ore, fully from January 2020, so that it would be processed at home. Chinese firms built smelters, and the government says nickel exports rose from about $1 billion in the mid-2010s to about $21 billion in 2021. But most smelters are foreign-owned and coal-powered, and in 2022 a WTO panel ruled against the ban.
Exam Matters: To evaluate infant industry protection, say what would make it succeed: a fixed end date and cost targets the industry must meet. Then judge whether the government in the case is likely to stick to them.
Protection can save jobs in the protected industry, but it often costs jobs in other industries.
The reason politicians give most often is to protect jobs. If cheap imports are forcing local factories to close, a tariff (a tax on imports) lets those factories sell more at home. Output and jobs in the protected industry rise, and everyone can see them.
But the jobs saved are not the whole story. Many other firms use the protected good to make their own products. When its price rises, their costs rise too, and they may cut output and jobs.
There are two more costs. Consumers pay higher prices, so they have less to spend on other goods. And countries that lose sales may retaliate by taxing the country's own exports, which puts jobs in exporting industries at risk.
Retaliation: action by a country to impose its own trade barriers in response to barriers imposed by another country.
Real Example: In 2019 the EU limited steel imports with quotas, charging a 25% tariff on any steel above them, to protect its steelmakers. In 2025 the European Commission proposed nearly halving the quotas and raising that tariff to 50%. Europe's car makers warned that firms using steel would face billions of euros a year in extra costs, the hidden side of protecting steel jobs.
Exam Matters: When you analyse this reason, build a chain: tariff, higher price of the good, higher costs for firms that use it, fewer jobs in those firms. Going beyond the jobs saved shows that you understand the full effect.
Some goods matter so much in a crisis that a country may choose to produce them at home, even at a higher cost.
Imagine a country that buys all its fuel, food or weapons from abroad. If a war or a blockade cut off those supplies, it would be in serious trouble. So governments sometimes protect industries they believe the country cannot do without.
Strategic industry: an industry considered vital to a country's defence or survival, such as energy, food or weapons production.
Producing these goods at home usually costs more, so consumers or taxpayers pay extra every year. You can think of it as insurance. The country pays a regular cost to avoid a rare but very serious problem.
The argument has two weaknesses. Almost any industry can claim to be strategic, and the claim is hard to prove wrong. There may also be cheaper ways to get the same security, such as keeping stockpiles or buying from many different countries.
Real Example: In March 2020, as COVID-19 spread, India restricted exports of 26 medicines and their ingredients, including paracetamol, because it feared shortages at home. India itself relied on China for most of the ingredients. It lifted most of the limits within about a month, but countries that bought their medicines from India saw how quickly a trusted supplier can stop selling in a crisis.
Exam Matters: To evaluate the national security argument, ask two questions. Is the industry really vital in a crisis? Is protection the cheapest way to keep supplies safe?
Dumping means selling exports below cost or below the price at home. Governments can respond with extra tariffs.
Sometimes a foreign firm sells its goods abroad at a very low price, lower even than it costs to make them. Why would it do this? It may want to get rid of spare output, or to drive rival firms out of the market so that it can raise prices later.
Dumping: selling goods in a foreign market at a price below their cost of production, or below the price charged in the producer's home market.
Dumping can seem good for consumers, because prices are low. But if domestic producers are forced out of business, jobs are lost. The foreign firm may then raise its prices once it has the market to itself.
Anti-dumping duty: a tariff placed on imports that are judged to be dumped, usually set to close the gap between the dumped price and a fair price.
Cheap imports are not always dumping. A foreign firm may simply be more efficient, pay lower wages or produce on a larger scale. The importing country has to show that the price is below the firm's own costs or its home price, and this is often hard to prove.
Real Example: In 2013 the EU put anti-dumping measures on solar panels from China, after European makers complained that Chinese panels were being sold below cost. European companies that install solar panels argued that the measures raised their costs and slowed the growth of solar power. The EU removed the measures in 2018.
Exam Matters: If you are asked to define dumping, include both parts: below the cost of production, or below the price in the home market. Writing only "selling very cheaply" describes the effect, not the meaning.
Governments may restrict imports to reduce a current account deficit, or tax imports because it is an easy way to raise money.
A country has a current account deficit when it pays out more to the rest of the world, mainly for imports, than it earns, mainly from exports. Tariffs (taxes on imports) can cut spending on imports, so less money flows out and the deficit shrinks.
Current account deficit: when the value of a country's imports of goods and services, plus income and transfers paid abroad, is greater than the value of its exports, plus income and transfers received from abroad.
The problem is that tariffs do not fix the cause. If exports are weak because they are too expensive or of poor quality, a tariff does not change that. A tariff on parts and materials can even raise exporters' costs. Trading partners may also retaliate with tariffs of their own.
A tariff is a tax, so it raises money for the government. It is also cheap and easy to collect, because goods arrive through a few ports and airports where they are counted. This matters most in lower-income countries.
Real Example: In April 2025 the United States put a 10% tariff on almost all imports, with higher rates set by a formula based on its trade deficit with each country. China hit back with tariffs of up to 125% before both sides cut them in May. For 2025 as a whole, the US trade deficit, about $900 billion, was almost the same as in 2024.
Exam Matters: To evaluate the deficit reason, use two counter-arguments: tariffs do not fix the cause, and retaliation can cut exports. For the revenue reason, ask whether the country has other taxes it could use instead.
A tariff is a tax on imports. It raises the price at home, so domestic firms make more, imports fall and consumers lose surplus.
Tariff: a tax on imported goods, which raises their price in the domestic market.
Suppose a good sells on the world market at $20. Domestic firms supply 20 units, consumers want 100, and imports fill the gap of 80.
Now the government adds a $10 tariff on each imported unit. Imports cost $30, so domestic firms can charge $30 too. They supply 40 units, and consumers buy only 80.
Imports fall for two reasons: domestic firms make more, and consumers buy less. The government collects $10 on each of the 40 units still imported, which is $400 of revenue.
Most buyers would pay more than the price if they had to, and most sellers would accept less. Those gaps are their surplus.
Consumer surplus: the difference between the price consumers are willing to pay for a good and the price they actually pay.
Producer surplus: the difference between the price producers receive for a good and the lowest price at which they would be willing to supply it.
When the price rises from $20 to $30, consumers lose surplus. On the tariff diagram their loss splits into four areas:
Areas a and c are transfers: they move from consumers to someone else in the country. Areas b and d go to nobody, and together they are the deadweight loss.
Deadweight loss: a loss of consumer or producer surplus that is not gained by anyone else, caused by a misallocation of resources; also called a welfare loss.
Real Example: In January 2024 Brazil brought back an import tax on electric cars, at 10% rising to 35% by July 2026. China's BYD bought a former Ford factory in Camaçari and began assembling cars there in July 2025, so those cars pay no import tax. Building a factory inside a country to avoid its tariff is called tariff-jumping investment.
Exam Matters: Give a chain for each effect of a tariff. On a diagram, label the world price, the price with the tariff, the four quantities and areas a to d.
A quota limits the quantity of imports. Like a tariff it raises the price at home, but no tax is collected.
Quota: a limit on the quantity, or value, of a good that can be imported in a given period.
Take a market where the world price is $20, domestic firms supply 20 units and consumers want 100. The government now allows only 40 units to be imported. With less on sale, the price at home rises.
It rises to $30. At that price domestic firms supply 40, consumers buy 80, and the other 40 are imported. This is exactly what a $10 tariff would do.
The difference is who gets the $10 gap on each imported unit. With a tariff, the government collects it as revenue. With a quota, whoever holds an import licence buys at $20 and sells at $30, so the $400 goes to them as quota rent.
Quota rent: the extra profit earned by holders of import licences, equal to the difference between the domestic price and the world price on each unit imported.
On the tariff diagram, only area c changes: it becomes quota rent. The deadweight loss, areas b and d, is the same.
If the licences are given to foreign exporters, the $400 leaves the country. If the government sells the licences, it can collect the money itself.
Real Example: In 1981 Japan agreed to limit the number of cars it exported to the United States. This worked like a quota. With fewer Japanese cars on sale, their prices in the US rose, and Japanese car makers kept the extra money, so the quota rent went to foreign firms.
Exam Matters: If a question asks you to compare a tariff and a quota, cover two differences. First, who receives the gap between the home price and the world price. Second, a quota fixes the quantity of imports, while a tariff fixes the extra cost of each import.
Non-tariff barriers restrict imports through rules and red tape instead of taxes. They are often hard to spot and hard to challenge.
Tariffs around the world are much lower than they were fifty years ago. So governments that want to limit imports often use other methods. These are called non-tariff barriers. Some textbooks count quotas as non-tariff barriers too.
Non-tariff barrier: a restriction on imports other than a tariff, such as strict product standards, licensing rules or slow customs procedures.
Many standards protect consumers and are perfectly fair. They become a barrier when they are written so that only domestic firms can easily meet them. This makes non-tariff barriers hard to challenge, because a government can always say a rule is for safety.
Like a quota, a non-tariff barrier reduces imports and raises the price at home. But much of the extra cost is often used up on tests, paperwork and delays. Nobody collects it, unlike tariff revenue or quota rent.
Real Example: Since 1989 the EU has banned beef from cattle given growth hormones, saying it could be a health risk. The United States and Canada argued it was protection in disguise, and in 1998 the World Trade Organization ruled against the EU. The EU kept the ban, and the US and Canada put tariffs on some EU exports in response.
Exam Matters: When you explain a non-tariff barrier, name the type and say how it raises the cost of importing, for example extra testing or delays at the border. Then judge whether it mainly protects consumers or domestic producers.
A subsidy pays domestic firms to produce more. Imports fall, but consumers still pay the world price.
Subsidy: a payment from the government to producers that lowers their costs of production and encourages them to supply more.
Instead of taxing imports, a government can pay its own producers. Suppose the world price is $20, domestic firms supply 20 units and consumers want 100. The government pays domestic firms $10 for every unit they make.
Domestic firms now receive $30 a unit: $20 from the buyer and $10 from the government. So the supply curve shifts from S to S', and they supply 40 units. Consumers still pay $20, so they still buy 100, and imports fall from 80 to 60.
The government pays $10 × 40 = $400. Part becomes extra producer surplus. The rest pays for making 20 units at home instead of importing them at $20: area b, the same waste as under a $10 tariff.
The subsidy avoids area d. Consumers still pay $20 and still buy 100, so the deadweight loss is smaller. But the government pays out instead of collecting, and that money has other uses.
Real Example: In 2020 India began paying phone makers a production-linked incentive: 4% to 6% of their extra sales of phones made in India. Samsung and Foxconn, which assembles iPhones, signed up. India's mobile phone exports rose to about $24 billion in 2024-25. Unlike a tariff, the payment helps firms sell abroad as well as at home.
Exam Matters: If asked which tool protects an industry with the least harm, the subsidy is usually the answer, because consumer prices do not rise. To evaluate, add the opportunity cost: the money could have been spent on health or education.
Each area is a rectangle or a triangle, so you can measure who gains, who loses and how much is simply lost.
To say how much each group gains or loses, you measure the areas on a tariff diagram. Take a world price of $20 and a $10 tariff. Domestic supply rises from 20 to 40 units, and demand falls from 100 to 80.
Every area is a rectangle, a right-angled triangle, or both. The height is always the tariff, $10, and the base is a quantity. A rectangle is base × height. A triangle is half a rectangle: ½ × base × height.
Check the total another way. Consumers pay $10 more on each of the 80 units they still buy, which is $800. They also lose $100 of surplus on the 20 units they stop buying. That is $900, the same as a + b + c + d.
Producers and the government gain $700. The other $200, areas b and d, is the deadweight loss. A $10 subsidy would lose only area b, $100.
Take care with area d. It is not the value of the 20 units. Consumers valued them at $500 in all and would have paid $400, so only the $100 of surplus is lost.
Real Example: After the United States raised tariffs on many imports in 2018 and 2019, several studies found that almost the whole tariff was passed on to American buyers as higher prices. So American consumers and firms paid most of the cost, not the countries whose goods were taxed.
Exam Matters: Show the working for each area. Then explain that the deadweight loss exists because consumers lose more than producers and the government gain together.
Domestic producers gain from a tariff on all their output. The government gains revenue, but only on imports that still arrive.
Take a market where a $10 tariff raises the price at home from $20 to $30. Domestic producers gain area a, worth $300, and the gain comes in two parts.
The bigger part is paid for goods firms were already making. The gain is also shared by a few firms, while the loss is spread thinly across millions of consumers. That is one reason firms lobby hard for protection, and consumers rarely organise against it.
Tariff revenue has a limit. The government only collects it on imports that still come in. A tariff so high that it stops all imports protects the industry completely but raises nothing.
Real Example: In the EU, tariffs on goods from outside the bloc are collected by the country where the goods arrive, often a big port such as Rotterdam in the Netherlands. That country keeps 25% to cover the cost of collecting, and the other three-quarters goes to the EU budget. So the government that gains area c is not always the government of the buyers who pay the tariff.
Exam Matters: If a question asks about producers, split their gain into the higher price on existing output and the surplus on extra output. For governments, compare the tools: a tariff raises revenue, a quota usually raises none, and a subsidy costs money.
Protection usually lowers living standards through higher prices, less choice and weaker competition. But it can support particular towns.
Living standards depend on what people can buy with their income. Protection raises prices, so the same income buys less. Real incomes fall, even though nobody's wages have been cut.
Real income: income adjusted for changes in prices, showing the quantity of goods and services it can buy.
Over time, weaker competition can do lasting damage. A protected industry that stops improving can fall further behind foreign rivals every year.
Protection can support living standards in one place. If a town depends on a single large factory, its closure can leave many families without income for years. Protection may keep those jobs while the town finds new work, even if the country as a whole loses.
Real Example: Japan protects its rice farmers with very high tariffs on imported rice. As a result, Japanese households pay much more for rice than the world price. Many rice farmers are older people in rural areas, so the policy supports those communities at a cost to every rice buyer in the country.
Exam Matters: To evaluate the effect on living standards, separate the country as a whole from the people directly affected. Then judge which matters more for the policy in the question, and over what time period.
A tariff works like a tax on spending, so it hits poorer households hardest. It can also widen gaps between countries.
A tariff raises the price of goods, so it works like a tax on spending. Poorer households spend a larger share of their income on basics such as food and clothing. So a tariff on these goods takes a bigger share of a poor family's income than a rich family's.
Regressive tax: a tax that takes a larger proportion of income from people on low incomes than from people on high incomes.
For example, suppose a tariff adds $10 a month to a family's food bill. For a family earning $500 a month, that is 2% of its income. For a family earning $5,000 a month, it is 0.2%.
There is another side. If the protected industry employs many low-paid workers, protection may keep their wages coming in. Whether equality gets better or worse depends on who buys the protected good and who makes it.
When rich countries protect their farmers or textile makers, poorer countries are often hurt most. These are the goods many lower-income countries are best at exporting. So protection by rich countries can widen the gap between rich and poor nations.
Real Example: The United States has long given large subsidies to its cotton farmers. Cotton-growing countries in West Africa, such as Mali, Burkina Faso, Benin and Chad, have argued at the World Trade Organization that these subsidies push down world cotton prices. Their cotton farmers are among the poorest in the world, so the lower price cuts incomes that are already very low.
Exam Matters: For an effect on equality, look at both sides: higher prices on goods that poorer households buy, and jobs or wages in the protected industry. Then say which is likely to be larger for the good in the question.
Countries make more of some goods and buy the rest from abroad. This brings real gains, but also real risks.
A country can be better at making everything and still gain from trade. What matters is what it gives up.