The Small-Country Case

As usual, it is convenient to start with a small country, so we can assume that the world terms of trade remain unchanged. Country A will maximize its welfare by producing at the point where its domestic ratio of marginal costs equals the world terms of trade, and then by engaging in trade in order to reach the highest possible indifference curve.

Such a free-trade equilibrium is shown in Figure 6, with the world price ratio shown by the slope of TT, production at point P₁, and consumption at point C₁, where TT is tangent to the indifference curve i₂. Country A exports cloth and imports food.

Now if Country A imposes a tariff on its imports of food, the first effect will be to increase the domestic price of food, thus causing a divergence between the domestic terms of trade and the world terms of trade. We show this effect in Figure 6 the domestic terms of trade become equal to the slope of DD, which is flatter than TT, indicating a higher relative price of food. It is said that the tariff drives a wedge between the domestic and external price ratios: geometrically, that wedge can be seen as the angle between the two price lines. The higher price of food induces firms to expand food production and to reduce cloth production. The production point moves to Pw, where the domestic price line (DD) is tangent to the production-possibility curve.

Because we are assuming that the world price ratio remains unchanged, inter-. national trade takes place along the line P₂C₂ (parallel to TT). A new equilibrium in consumption is reached when two conditions are satisfied: (1) A domestic price

Cloth

FIGURE 6 The effects of a tariff: general equilibrium, small-country case.

line, EE, whose slope is equal to the tariff-distorted domestic price ratio, is tangent to a community indifference curve; and (2) the world price line, P₂C₂, intersects the community indifference curve at its point of tangency with the domestic p' line, EE. These two conditions are both satisfied at the point C₂ in Figure 6 Technically, the first condition guarantees that the marginal rate of substitution in consumption equals the domestic price ratio facing consumers; the second condition satisfies the requirement that the domestic price ratio diverges from the world price ratio exactly in proportion to the tariff.

In the new equilibrium, Country A continues to export cloth and import foodbut in smaller quantities than before. The tariff has stimulated domestic production of food, reducing Country As dependence on food imports. It has also reduced domestic output and exports of cloth and reduced welfare, as indicated by the movement to the lower indifference curve, from i₂ to i₁. Thus we reach the same conclusion in both general and partial equilibrium analysis: In the small-country case a tariff reduces national welfare.

Дата добавления: 2015-11-14