International Trade

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

Let's consider what happens to a small country that produces two goods. As before, because it is a small country, its terms of trade do not change.

Free Trade

Producers



The country produces two goods M and X. We'll assume that the country's production possibility frontier, which shows the trade-off between production of the two goods (due to resource constraints and technology), is a smooth curve SS. [1]

The actual production depends on the relative prices of X and M, PX and PM. In free trade, these prices are set by the world market.

The points of constant value form lines with the same gradient - the ratio of PX to PM. The economy will attempt to maximise the value of its output.

For example, lines that are too low [2] indicate an inefficient use of resources - production can increase. On the other hand, lines that are too high [3] have higher value, but are beyond the production capacity of this country.

In fact, the economy will produce its highest value possible at a point F where the value line is tangent to SS. [4] This corresponds to a certain mix of M and X. [5] This condition is P = PM/PX = MRT (marginal rate of transformation).

If the economy produces somewhere else, say at G, [6] then the economy can reach any point on the line b by trade. It is clear that the value of output represented by this line is not as high as that by the line a.

Consumers



What about consumers? They will aim to maximise their utility, so in a similar way their optimum consumption point is C0, [1] the point on the indifference curve that is tangent to the price line. This corresponds to a demand for a certain mix of M and X. [2] This condition is P = PM/PX = MRS (marginal ate of substitution).

If we compare consumer demand with production, we find that they are not the same. [3] The consumer demand for M is higher than its domestic production, and the demand for X is lower than its domestic production. So the country imports M [4] and exports X, [5] given world price P = PM/PX.

Protection

Now consider what happens when this country imposes a tariff t on one of the products - M. This increases the price of M to PM(1+t). This means that the line of constant value is now steeper, so production moves to E. [1] This is logical - the price of M is higher, so producers will produce more of M.

Now, although the domestic price ratio is higher, the country still trades at world prices (Remember that the domestic price is not the same as the world price). [2] At first, it might appear that consumers would choose the point C1 to maximise their utility. [3] However, this point is not available to them because they have to pay the steeper domestic price for M. Thus, they actually maximise utility at C2. [4]

If we compare the mix of M and X produced by the country [5] with the demand, [6] again there is a difference. This time, the country imports less of M. [7]

Remember that they produce following the domestic price, trade following the world price, and then they consume following the domestic price. Therefore, after producing at E (where domestic price ratio = MRT), they will reach somewhere on C following the world price.

At the optimal point, the domestic price ratio must be the same as the MRS. C2 is the only point that satisfies these two conditions: It is on C and the domestic price ratio is equal to the MRS.


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[Topic] Tariffs


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[mtcha@ecel.uwa.edu.au]
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