O n l i n e A p p e n d i x A t o International Economics

and International Trade C h a p t e r 9

Tariff Analysis in General Equilibrium

• Chapter 9 in International Economics and International Trade takes a partial equilib-
rium approach to the analysis of trade policy. That is, it focuses on the effects of tariffs,
Partial Equilibrium Approach:
Focuses on the effects of quotas, and other policies in a single market without explicitly considering the conse-
trade policies in a single quences for other markets. This partial equilibrium approach usually is adequate, and
market without considering it is much simpler than a full general equilibrium treatment that takes cross-market
cross-market effects.
effects into account. Nonetheless, it is sometimes important to do the general equilib-
• rium analysis. In Chapter 6 of International Economics and International Trade, we pre-
General Equilibrium Analysis:
sented a brief discussion of the effects of tariffs in general equilibrium. This appendix
Analyzes the effects of trade presents a more detailed analysis.
policies across all markets, The analysis proceeds in two stages. First, we analyze the effects of a tariff in a
considering cross-market
effects. small country, one that cannot affect its terms of trade; then we analyze the case of a
large country.
•

Tariff Analysis Stages: First, A Tariff in a Small Country

analyze in a small country
that cannot affect its terms of
Imagine a country that produces and consumes two goods, manufactures and food.
trade; then, analyze in a large The country is small, unable to affect its terms of trade; we will assume that it exports
country. manufactures and imports food. Thus the country sells its manufactures to the world
market at a given world price P*M and buys food at a given world price P*F.
Figure 1 illustrates the position of this country in the absence of a tariff. The econ-
omy produces at the point on its production possibility frontier that is tangent to a
line with slope -P*M >P*F, indicated by Q1. This line also defines the economy’s budget
constraint, that is, all the consumption points it can afford. The economy chooses
the point on the budget constraint that is tangent to the highest possible indifference
curve; this point is shown as D1.

Figure 1
Food production and
Free Trade Equilibrium for consumption, QF, DF
a Small Country
The country produces at the D1
point on its production frontier
that is tangent to a line whose
slope equals relative prices, and
it ­consumes at the point on the
budget line tangent to the highest
possible indifference curve.
slope = –PM*/PF*
Q1

Manufactures production and

consumption, QM, DM

A-1

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 A-2 Online Appendix A to Chapter 9

Figure 2
QF , DF
A Tariff in a Small Country
The country produces less of
its export good and more of its
D2
­imported good. Consumption
is also distorted. The result is a
­reduction in both welfare and the slope = –PM* /PF* (1 + t )
volume of the country’s trade.
Q2

Manufactures production and

consumption, QM, DM

Now suppose that the government imposes an ad valorem tariff at a rate t Then the
price of food facing both consumers and domestic producers rises to P*F 11 + t2, and
the relative price line therefore gets flatter, with a slope -P*M >[P*F 11 + t2].
The effect of this fall in the relative price of manufactures on production is straight-
forward: Output of manufactures falls, while output of food rises. In Figure 2, this
shift in production is shown by the movement of the production point from Q1, shown
in Figure 1, to Q2.
The effect on consumption is more complicated; the tariff generates revenue, which
must be spent somehow. In general, the precise effect of a tariff depends on exactly
how the government spends the tariff revenue. Consider the case in which the gov-
ernment returns any tariff revenue to consumers. In this case the budget constraint
of consumers is not the line with slope -P*M >[P*F 11 + t2] that passes through the
production point Q2; consumers can spend more than this, because in addition to the
income they generate by producing goods, they receive the tariff revenue collected by
the government.
How do we find the true budget constraint? Notice that trade must still be balanced
at world prices. That is,

P*M * 1QM - DM 2 = P*M * 1DF - QF 2,

where Q refers to output and D to consumption of manufactures and food. The

­left-hand side of this expression therefore represents the value of exports at world
prices, while the right-hand side represents the value of imports. This expression may
be rearranged to show that the value of consumption equals the value of production
at world prices:

P*M * QM + P*F * QF = P*M + DM + P*F * DF.

This defines a budget constraint that passes through the production point Q2, with
a slope of -P*M >P*F. The consumption point must lie on this new budget constraint.

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 Online Appendix A to Chapter 9 A-3

Consumers will not, however, choose the point on the new budget constraint at
which this constraint is tangent to an indifference curve. Instead, the tariff causes
them to consume less food and more manufactures. In Figure 2 the consumption
point after the tariff is shown as D2: It lies on the new budget constraint, but on an
indifference curve that is tangent to a line with slope -P*M >[P*F 11 + t2]. This line lies
above the line with the same slope that passes through the production point Q2; the
difference is the tariff revenue redistributed to consumers.
By examining Figure 2 and comparing it with Figure 1, we can see three important
• points:

Welfare Reduction Effects:

Economy no longer produces at 1. Welfare is less with a tariff than under free trade. That is, D2 lies on a lower indif-
the maximum value of income ference curve than D2.
at world prices and consumers
don’t choose the welfare- 2. The reduction in welfare comes from two effects. (a) The economy no longer pro-
maximizing point on the budget duces at a point that maximizes the value of income at world prices. The budget
constraint.
constraint that passes through Q2 lies inside the constraint passing through Q1. (b)
• Consumers do not choose the welfare-maximizing point on the budget constraint;
thus they do not move up to an indifference curve that is tangent to the economy’s
Reason for Welfare Loss:
Domestic consumers and
true budget constraint. Both (a) and (b) result from the fact that domestic con-
producers face prices different sumers and producers face prices that are different from world prices. The loss in
from world prices. welfare due to inefficient production (a) is the general equilibrium counterpart of
• the production distortion loss we described in the partial equilibrium approach in
this chapter, and the loss in welfare due to inefficient consumption (b) is the coun-
Welfare Loss Components: terpart of the consumption distortion loss.
Inefficient production and
inefficient consumption. 3. Trade is reduced by the tariff. Exports and imports are both less after the tariff is
imposed than before.

These are the effects of a tariff imposed by a small country. We next turn to the effects
of a tariff imposed by a large country.

A Tariff in a Large Country

To address the large country case, we use the offer curve technique developed in the
Online Appendix B to Chapter 6 of International Economics and International Trade.
We consider two countries: Home, which exports manufactures and imports food, and
its trading partner, Foreign. In Figure 3, Foreign’s offer curve is represented by OF.
Home’s offer curve in the absence of a tariff is represented by OM 1. The free trade
equilibrium is determined by the intersection of OF and OM 1, at point 1, with a rela-
tive price of manufactures on the world market 1P*M >P*F 2 1.
Now suppose that Home imposes a tariff. We first ask, how would its trade change
if there were no change in its terms of trade? We already know the answer from the
small country analysis: For a given world price, a tariff reduces both exports and
imports. Thus if the world relative price of manufactures remained at 1P*M >P*F 2 1,
Home’s offer would shift in from point 1 to point 2. More generally, if Home imposes
a tariff, its overall offer curve will shrink in toward a curve like OM 2, passing through
point 2.
But this shift in Home’s offer curve will change the equilibrium terms of trade.
In Figure 3, the new equilibrium is at point 3, with a relative price of manufactures
1P*M >P*F 2 2 7 1P*M >P*F 2 1. That is, the tariff improves Home’s terms of trade.

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 A-4 Online Appendix A to Chapter 9

Figure 3
Home imports of food, DF – QF
Effect of a Tariff on the Terms Foreign exports of food, QF* – DF*
of Trade
The tariff causes the country to slope = (PM* /PF* )2 slope = (PM* /PF* )1
trade less at any given terms of
trade; thus its offer curve shifts M1
in. This implies, however, that M2
the terms of trade must improve.
The gain from improved terms 3 1
F
of trade may offset the losses
from the distortion of production
and consumption, which reduces
­welfare at any given terms of 2
trade.

O Home exports of manufactures, QM – DM

Foreign imports of manufactures, DM*– QM *

The effects of the tariff on Home’s welfare are ambiguous. On one side, if the terms
of trade did not improve, we have just seen from the small country analysis that the
tariff would reduce welfare. On the other side, the improvement in Home’s terms of
trade tends to increase welfare. So the welfare effect can go either way, just as in the
partial equilibrium analysis.

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