Model Answer
0 min readIntroduction
In the realm of international trade, the concept of an ‘optimum tariff’ attempts to identify the tariff rate that maximizes a country’s welfare. This idea, developed by Robert Torrens and further refined by Frank Taussig, suggests that a large country can improve its terms of trade and national income by imposing a tariff. The determination of this optimum tariff relies heavily on the understanding of ‘offer curves’, which graphically represent the supply and demand conditions of a country in international trade. This answer will explain how the intersection of offer curves helps determine the optimum tariff rate for a country.
Understanding Offer Curves
An offer curve is a graphical representation of the amounts of a country’s exports that it is willing to supply at various relative price levels. It shows the relationship between the price of exports in terms of imports and the quantity of exports offered. The offer curve is upward sloping, reflecting the principle of comparative advantage – a country will export more of the goods it produces relatively cheaply.
Determining the Optimum Tariff with Offer Curves
The optimum tariff is found at the point where the offer curves of two trading countries are tangent to each other. This point represents the equilibrium terms of trade (TOT) where both countries maximize their welfare. Let's consider two countries, A and B.
- Graphical Representation: Imagine a diagram with the relative price of exports (Country A’s exports in terms of Country B’s imports) on the Y-axis and the quantity of exports on the X-axis. Draw the offer curves of both countries, OA and OB.
- Equilibrium TOT: The point of tangency between OA and OB determines the equilibrium TOT. At this point, the quantities of exports offered by both countries are equal.
- Imposing a Tariff: Now, suppose Country A imposes a tariff on its imports. This shifts its offer curve (OA) upwards and to the left (OA’).
- New Equilibrium: The new point of tangency between OA’ and OB determines the new TOT. Country A gains because it receives a more favorable exchange rate for its exports.
- Optimum Tariff Rate: The difference between the original TOT and the new TOT, expressed as a percentage of the value of trade, represents the optimum tariff rate.
Welfare Implications
The optimum tariff argument suggests that a large country can improve its welfare by imposing a tariff. This is because the tariff improves the terms of trade, leading to:
- Increased National Income: The improved TOT results in a higher value of exports relative to imports, increasing national income.
- Consumer Surplus: Consumers may benefit from lower prices on imported goods (though this is often offset by higher prices on domestically produced substitutes).
- Producer Surplus: Domestic producers benefit from increased protection and higher prices.
Limitations of the Optimum Tariff Argument
Despite its theoretical appeal, the optimum tariff argument has several limitations:
- Retaliation: The country imposing the tariff risks retaliation from its trading partners, leading to a trade war and a reduction in overall welfare.
- Small Country Assumption: The argument is only valid for large countries that can influence world prices. Small countries have little impact on global markets.
- Administrative Costs: Implementing and administering tariffs involves administrative costs.
- Distortion of Resource Allocation: Tariffs distort resource allocation by encouraging domestic production of goods in which the country does not have a comparative advantage.
- Dynamic Effects: The static analysis ignores dynamic effects like innovation and technological progress.
Furthermore, the assumption of a stable offer curve is often unrealistic in the dynamic world of international trade.
Conclusion
The concept of the optimum tariff, determined through the intersection of offer curves, provides a theoretical framework for understanding how a large country might benefit from strategic tariff imposition. However, the practical application of this theory is limited by the potential for retaliation, the assumption of a large country, and the inherent distortions caused by trade barriers. Modern trade policy increasingly focuses on reducing tariffs and promoting free trade agreements, recognizing the overall benefits of open markets despite the theoretical allure of the optimum tariff.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.