Remembering the optimum tariff analysis of Chapter 15, explain why it might be p
ID: 1223422 • Letter: R
Question
Remembering the optimum tariff analysis of Chapter 15, explain why it might be possible that the imposition of a tariff by an LDC to improve its terms of trade (and thus hopefully to be in a better position at the start of any future deterioration) could reduce the LDC’s welfare. Build the reverse case that reduction of an LDC tariff might improve the LDC’s welfare at the present time, even though the terms of trade deteriorate because of the tariff reduction.
Book: International Economics - Appleyard, Field, & Cobb - 7th Edition
Chapter 18 Question 2
Explanation / Answer
Terms of trade is the ratio of total value of exports and total value of imports. It measures the relative price of exports in terms of imports. It determines on what terms the two countries involved in trade exchange goods between them. An improvement in TOT implies that the country can export more and import less so that the overall welfare is increased. A deteriorating TOT means that the export prices have fallen relative to import prices (or that import prices have risen in relation to export prices)
A tariff increases the price of a product in the domestic market so as to discourage imports and encourage local production of goods. Thus, a tariff is more likely to depress domestic demand and a loss in the consumer surplus. It may be alluring for a small country (economically, like LDCs) to impose tariff and earn the gains of trade since then the total volume of imports will be reduced.
But when tariffs are imposed, the overall welfare is reduced as explained by the Prebisch-Singer hypothesis. What happens is that these nations have low income elasticity of demand, and they are more or less labor intensive. Hence, when a tariff is imposed on imported goods, the production distortion loss results from the fact that the tariff leads domestic producers to produce too much of this good. Then there is a domestic consumption distortion loss resulting from the fact that a tariff leads consumers to consume too little of the good. There is a terms of trade gain that results from the decline in the foreign export price caused by a tariff. In the important case of a small country like LDCs that cannot significantly affect foreign prices, this last effect drops out; thus the costs of a tariff unambiguously exceed its benefits
Hence, the overall TOT deteriorates. Producers lose because domestically produced goods are less purchased and exports are reduced. Consumers are at a loss too since domestic price level rises. Hence the overall welfare is reduced.