4.4 The Terms-of-Trade Effect and a Nationally Optimal Tariff

Now, suppose the large importing country imposes an import tariff. By increasing the selling cost, the tariff raises the domestic price to [latex]\text{P}_{bt}[/latex]. The increase in the domestic price leads to an increase in domestic production from [latex]\text{Q}_{sw}[/latex] to [latex]\text{Q}_{st}[/latex] and a reduction in domestic consumption from [latex]\text{Q}_{dw}[/latex] to [latex]\text{Q}_{dt}[/latex]. As a result, the quantity of imports falls to the difference between [latex]\text{Q}_{dt}[/latex] and [latex]\text{Q}_{st}[/latex]. In the domestic market, consumer surplus falls by the sum of areas [latex]\textit{a}[/latex], [latex]\textit{b}[/latex], [latex]\textit{c}[/latex], and [latex]\textit{d}[/latex]. Meanwhile, producer surplus increases by area [latex]\textit{a}[/latex], as there is a transfer of economic surplus from consumers to domestic producers. The results of our analysis so far are similar to those in the case of a small importing country.

However, because the tariff leads to a reduction in the export price of the product, the price export suppliers receive, [latex]\text{P}_{st}[/latex], lies below the world price, [latex]\text{P}_{w}[/latex]. With the tariff is equal to the vertical difference between the price line [latex]\text{P}_{bt}[/latex] and [latex]\text{P}_{st}[/latex], government tariff revenue is equal to the quantity of imports multiplied by the tariff or the sum of area [latex]\textit{c}[/latex] and area [latex]\textit{e}[/latex]. Here, we can see that a portion of the tariff revenue is collected from domestic consumers, equal to area [latex]\textit{c}[/latex], while the remainder is paid by foreign suppliers of the imported product, area [latex]\textit{e}[/latex]. This represents the terms-of-trade effect, which is a transfer of economic surplus from the exporting country to the importing country. A large importing country, therefore, can use an import tariff to improve its terms of trade and, consequently, increase its national well-being.

If we combined the effects of the tariff on consumers, domestic producers, and the national government, we can determine what economic impact the tariff has on the nation. The losses in consumer surplus of areas [latex]\textit{a}[/latex] and [latex]\textit{c}[/latex] are offset by gains, respectively, to producers and in government revenue. The part of the tariff that foreigners pay, area [latex]\textit{e}[/latex], represents a gain for the importing nation. The importing nation suffers the (usual) deadweight losses of area [latex]\textit{b}[/latex] and area [latex]\textit{d}[/latex], the production and consumption effects, respectively. This represents a deterioration in the nation’s well-being due to lower consumption and the switch of some consumption to higher-cost domestic production. Whether the importing country gains or loses in terms of economic well-being depends on the relative sizes of areas [latex]\textit{b}[/latex] and [latex]\textit{d}[/latex] and area [latex]\textit{e}[/latex]. If area [latex]\textit{e}[/latex] is greater than areas [latex]\textit{b}+{d}[/latex], the importing country is better off as a result of the tariff. If [latex]\textit{e}[/latex] is less than areas [latex]\textit{b}+{d}[/latex], the importing country is worse off as a result of the tariff. If the tariff is small, then areas [latex]\textit{b}[/latex] and [latex]\textit{d}[/latex] will be relatively small and the country is therefore more likely to gain from a tariff. If the tariff is large, then areas [latex]\textit{b}[/latex] and [latex]\textit{d}[/latex] will be large and the country is therefore less likely to gain from a tariff. Table 4.6 summarizes the economic effects of a tariff for a large country.

As seen earlier, a tariff can improve the terms of trade and the economic well-being of a large importing nation. However, the tariff lowers the large country’s wellbeing by reducing its consumption of lower-cost imports. Formally, the nation can obtain the highest net gain in economic wellbeing – net benefit – by maximizing the difference between the terms-of-trade effect and the efficiency loss stemming from the production and consumption effects. That is, a nationally optimal tariff maximizes the difference between area [latex]\textit{e}[/latex] and areas [latex]\textit{b}[/latex] + [latex]\textit{d}[/latex] in Figure 4.2.

The nationally optimal tariff, measured as a fraction of the price received by foreign suppliers, is equal to the reciprocal price elasticity of foreign supply of the imported product. The lower the elasticity of foreign supply, the higher the optimal tariff would be. The lower the elasticity of foreign export supply, the less choice foreign suppliers have in selling their exports and the more the large importing nation can extract surplus from the exporting country with a high tariff. If the supply of foreign exports is infinitely elastic (i.e., if foreign suppliers can readily switch sales to other countries), the tariff would hurt only the importing country, as domestic consumers bear the full burden of the tariff. In this case, the optimal tariff is zero, and free trade would be the best policy for the importing country.

In the large-country case, even though the importing country can benefit as economic surplus is redistributed from foreign suppliers, the nationally optimal tariff will still be bad for the world. This is because foreign suppliers lose more than the surplus transferred to the importing nation. Not only do they receive lower prices, they also experience a drop in their sales as exports are reduced by the tariff. In addition, while our discussion up to this point has assumed that there is no retaliation, the exporting country is likely to retaliate in real-world situations, which would lead to further losses in economic surplus. If many nations apply optimal tariffs, they are likely to experience decreases in economic well-being as the level of world trade falls.