Let's consider what happens to a small country's imports and exports. As before, because it is a small country, its terms of trade do not change.
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The country produces two goods M and X. Suppose it has only one
factor of production and the technology is CRS (constant returns to
scale), so that its production possibility frontier
is a straight line with a slope indicating the relative price of M
to X.
Consumers will attempt to maximise their utility, choosing an
indifference curve that is tangent to the production possibility
frontier, say at T1.
By trade and specialisation, this country can expand its consumption beyond that of its own production possibility frontier, depending on the world price. For example, if the world price is higher than the domestic price, the economy produces X only (at X0) and then consumers maximise their utility at a different point, T2, by trade. If we connect all the optimal consumption points (T1, T2, ...) with various prices, we produce a curve. This is called the offer curve - it shows how the country's imports and exports vary with the relative price. (In this graph, O coincides with X0). This small country trades on the world market with given fixed prices for M and X. Its equilibrium trade point is where its offer curve intersects the world price, at E. This represents imports of M1 and exports of X1. |
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By tariff, the world price PW is still the same, but
the domestic price changes from Pd (= PX/PM
at world prices) to P'd (= PX/P'M at
world prices),
where PM = PM(1+t) and
P'd < Pd.
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Question: Is X2 < X1 always? In other words, does the tariff on M result in higher or lower exports?
The answer is that this depends on the shape of the offer curve.
More detailed discussion is given in the lecture of the unit 400.450.