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Introduction

  • General equilibrium analysis of a tariff is most appropriate when the effect of tariff is examined on the nation as a whole. General equilibrium analysis is more complex in nature. General equilibrium analysis makes use of production possibility curves/ production frontiers/ transformation curve, community indifference curves, or offer curves.
  • General equilibrium analysis of a tariff is generally studies in two ways viz; general equilibrium analysis of a tariff in a small country and general equilibrium analysis of a tariff in a large country.
  • To analyse the general equilibrium effects of a tariff in a large nation, it is more convenient to utilise offer curves. Imposition of a tariff by a large nation reduces the volume of trade but improves the terms of trade.
  • This is to be contrasted to the case of a small country imposing a tariff, where the volume of trade declines but the terms of trade remain unchanged so that the small nation’s welfare invariably declines.
  • In the general equilibrium analysis, a study is made of the effects of tariff on consumption, production, trade and welfare. When a country imposes a tariff, not only a specific product or sector but practically every sector of the economy gets affected in one way or the other, until the economic system reaches a new equilibrium position.
  • In this connection, Kindelberger remarked that a tariff is “…likely to alter trade, prices, output and consumption, and to reallocate resources, change in factor proportions, redistribute income, change employment and alter the balance of payments.” The general equilibrium analysis of tariff is made from the viewpoint of a small country and a large country.

General Equilibrium Analysis of Tariff in a Small Country

  • When a very small nation imposes a tariff, it will not affect prices on the world market. However, the domestic price of the importable commodity will rise by the full amount of the tariff for individual producers and consumers in the small nation.
  • Although the price of the importable commodity rises by the full amount of the tariff for individual producers and consumers in the small nation, its price remains constant for the small nation as a whole since the nation itself collects the tariff.
  • For example, if the international price of importable commodity X is $1 per unit and the nation imposes a 100 percent ad valorem tariff on imports of commodity X, domestic producers can compete with imports as long as they can produce and sell commodity X at a price no higher than $2. Consumers will have to pay $2 per unit of commodity X, whether imported or domestically produced. (We assume throughout that the imported commodity and the domestically produced commodity are identical.)
  • However, since the nation itself collects the $1 tariff on each unit of commodity X imported, the price of commodity X remains $1 as far as the nation as a whole is concerned.
  • We further assume that the government of the small tariff-imposing nation uses the tariff revenue to subsidize public consumption (such as schools, police, etc.) and/or for general income tax relief. That is, the government of the small nation will need to collect less tax internally to provide basic services by using the tariff revenue.

Illustration of the Effects of a Tariff in a Small Country

  • We will illustrate the general equilibrium effects of a tariff by continuing to utilize our familiar Nation 1 and Nation 2 from previous chapters. We start by using Nation 2’s production frontier because it is somewhat more convenient for the type of analysis that we need to perform now.
  • The same analysis for Nation 1 is left as an end-of-chapter problem. The only conclusion that we need to remember from previous chapters is that Nation 2 is the capital-abundant nation specializing in the production of commodity Y (the capital-intensive commodity), which it exports in exchange for imports of commodity X.
  • From Figure 1, we see that if PX /PY = 1 on the world market and Nation 2 is too small to affect world prices, it produces at point B, exchanges 60Y for 60X with the rest of the world, and consumes at point E on its indifference curve III with free trade.
Figure 1
  • If the nation now imposes a 100 percent ad valorem tariff on imports of commodity X, the relative price of X rises to PX /PY = 2 for domestic producers and consumers but remains at PX /PY = 1 on the world market and for the nation as a whole (since the nation itself collects the tariff). Facing PX /PY = 2, domestic producers will produce at point F, where price line PF = 2 is tangent to the nation’s production frontier.
  • Thus, the nation produces more of importable commodity X and less of exportable commodity Y after imposition of the tariff than under free trade (compare point F to point B). The figure also shows that for exports of FG, or 30Y, the nation demands imports of GH , or 30X, of which GH , or 15X, goes directly to the nation’s consumers and HH (i.e., the remaining 15X) is collected in kind by the government in the form of the 100 percent import tariff on commodity X. Note that indifference curve II is tangent to the dashed line parallel to PF = 2 because individual consumers in the nation face the tariff-inclusive price of PX /PY = 2.
  • However, since the government collects and redistributes the tariff in the form of public consumption and/or tax relief, indifference curve II must also be on the dashed line parallel to PW = 1 (since the nation as a whole still faces the world price of PX /PY = 1).
  • Thus, the new consumption point H is defined by the intersection of the two dashed lines (and therefore is on both). The angle between the two dashed lines (which is equal to the angle between price lines PW = 1 and PF = 2) is equal to the tariff rate of 100 percent. With production at point F and consumption at point H, the nation exports 30Y for 30X after imposition of the tariff (as opposed to 60Y for 60X before imposition of the tariff).
  • To summarize, the nation produces at point B with free trade and exports 60Y for 60X at PW = 1. With the 100 percent import tariff on commodity X, PX /PY = 2 for individual producers and consumers in the nation but remains at PW = 1 on the world market and for the nation as a whole. Production then takes place at point F; thus, more of importable commodity X is produced in the nation with the tariff than under free trade. 30Y is exchanged for 30X, of which 15X is collected in kind by the government of the nation in the form of a 100 percent import tariff on commodity X. Consumption takes place at point H on indifference curve II after imposition of the tariff.
  • This is below the free trade consumption point E on indifference curve III because, with the tariff, specialization in production is less and so are the gains from trade. With a 300 percent import tariff on commodity X, PX /PY = 4 for domestic producers and consumers, and the nation would return to its autarky point A in production and consumption.
  • Such an import tariff is called a prohibitive tariff. The 300 percent import tariff on commodity X is the minimum ad valorem rate that would make the tariff prohibitive in this case. Higher tariffs remain prohibitive, and the nation would continue to produce and consume at point A.

General Equilibrium Analysis of a Tariff in a Large Country

  • To analyze the general equilibrium effects of a tariff in a large nation, it is more convenient to utilize offer curves. When a nation imposes a tariff, its offer curve shifts or rotates toward the axis measuring its importable commodity by the amount of the import tariff.
  • The reason is that for any amount of the export commodity, importers now want sufficiently more of the import commodity to also cover (i.e., pay for) the tariff. The fact that the nation is large is reflected in the trade partner’s (or rest of the world’s) offer curve having some curvature rather than being a straight line.
  • Under these circumstances, imposition of a tariff by a large nation reduces the volume of trade but improves the nation’s terms of trade. The reduction in the volume of trade, by itself, tends to reduce the nation’s welfare, while the improvement in its terms of trade tends to increase the nation’s welfare.
  • Whether the nation’s welfare actually rises or falls depends on the net effect of these two opposing forces. This is to be contrasted to the case of a small country imposing a tariff, where the volume of trade declines but the terms of trade remain unchanged so that the small nation’s welfare always declines.

Illustration of the Effects of a Tariff in a Large Country

  • The imposition by Nation 2 of a 100 percent ad valorem tariff on its imports of commodity X is reflected in Nation 2’s offer curve rotating to offer curve 2’ in Figure 2. Note that tariff-distorted offer curve 2’ is at every point 100 percent or twice as distant from the Y-axis as offer curve 2.
  • Before imposition of the tariff, the intersection of offer curve 2 and offer curve 1 defined equilibrium point E, at which Nation 2 exchanged 60Y for 60X at PX /PY = PW = 1.
  • After imposition of the tariff, the intersection of offer curve 2’ and offer curve 1 defines the new equilibrium point E’ , at which Nation 2’ exchanges 40Y for 50X at the new world price of PX /PY = P’W = 0.8. Thus, the terms of trade of Nation 1 deteriorated from PX /PY = PW = 1 to PX /PY = P’W = 0.8.
Figure 2
  • On the other hand, Nation 2’s terms of trade improved from PY /PX = 1/PW = 1 to PY /PX = 1/P’ W = 1/0.8 = 1.25. Note that for any tariff rate, the steeper or less elastic Nation 1’s (or the rest of the worlds) offer curve is, the more its terms of trade deteriorate and Nation 2’s improve.
  • Thus, when large Nation 2 imposes a tariff, the volume of trade declines but its terms of trade improve. Depending on the net effect of these two opposing forces, Nation 2’s welfare can increase, decrease, or remain unchanged.
  • This is to be contrasted to the previous case where Nation 2 was assumed to be a small nation and did not affect world prices by its trading. In that case, Nation 1’s (or the rest of the world’s) offer curve would be represented by straight line PW = 1 in Figure2.
  • Nation 2’s imposition of the 100 percent import tariff on commodity X then reduces the volume of trade from 60Y for 60X under free trade to 30Y for 30X with the tariff, at unchanged PW = 1 .
  • As a result, the welfare of (small) Nation 2 always declines with a tariff. Returning to our present case where Nation 2 is assumed to be large, we have seen in Figure 2 that with tariff-distorted offer curve 2’ , Nation 2 is in equilibrium at point E’ by exchanging 40Y for 50X so that PY /PX = P’W = 0.8 on the world market and for Nation 2 as a whole.
  • However, of the 50X imported by Nation 2 at equilibrium point E , 25X is collected in kind by the government of Nation 2 as the 100 percent import tariff on commodity X and only the remaining 25X goes directly to individual consumers. As a result, for individual consumers and producers in Nation 2, PX /PY = PD = 1.6, or twice as much as the price on the world market and for the nation as a whole.
  • Since the relative price of importable commodity X raises for individual consumers and producers in Nation 2, the Stolper–Samuelson theorem also holds (and w rises) when we assume that Nation 2 is large. Only in the unusual case where PX /PY falls for individual consumers and producers after the nation imposes a tariff will the theorem not hold and w fall in Nation 2. This is known as the Metzler paradox.
  • Also to be pointed out is that the Stolper–Samuelson theorem refers to the long run when all factors are mobile between the nation’s industries. If one of the two factors (say, capital) is immobile (so that we are in the short run), the effect of a tariff on factors’ income will differ from that postulated by the Stolper–Samuelson theorem.

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