International Trade

Tariffs - Large Country, General Equilibrium: Two-Good Case

Free Trade

Under free trade, the large country operates the same way as a small country:
  • Production is at F, tangent of the world price to the production possibility frontier SS. [1]
  • Consumption is at C0. [2]
  • The country imports M [3] and exports X. [4]
    		•

    Protection

    Now consider what happens when this country imposes a tariff t on M. As we have seen, this reduces the world price to P'M and increases the domestic price to P'M(1+t). As a result, the domestic price is P'M<(1+t)/PX (> PM/PX) and production moves to E. [1]

    In the small country case, we saw that imposing the tariff decreased the country's welfare because it was still forced to trade at world prices.

    Now, because the world price for M has been reduced to P'M, the country's terms of trade have increased, so it trades on a flatter line than for a small country (P'M/PX < PM/PX). As a result, consumption can now take place at C1, [2] with an increase in welfare.

    But note that if the world price changed by less, it could be possible for the optimal consumption point to be at, say, C'1, [3] with a decrease in welfare.

    Therefore, for a large country, there is an optimal tariff argument, where the country can choose a tariff to maximise its welfare.


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    [Topic] Tariffs


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