Question

1. Write short notes on:

a) Optimal Tariff

b) Trade Diversion and Trade Creation effects of Trade agreements

Answer 1

Solution: 1] An optimum tariff is a tax designed for maximizing the welfare of a country. Optimum tariffs are found in international trade. Only large countries use optimum tariffs and benefit from them. Small countries with small economies do not have optimum tariffs. The tariff in this case is considered zero. Large countries using optimum tariffs, however, are considered to have a positive tariff because of the effect on trade In the absence of retaliation, a country should be able to levy a tariff on imports which yields some optimal terms of trade and hence an optimal level of community welfare Beginning at the free trade position (or any tariff- distorted trade position) as a country raises its tariff unilaterally, the terms of trade improve and the volume of trade declines The improvement in the terms of trade initially, tends to more than offset the accompanying reduction in the volume of trade and hence a higher trade indifference curve is reached and community welfare is enhanced. Beyond some point, however, it is likely that the detrimental effect of successive reductions in trade volume will begin to outweigh the positive effect of further improvements in the terms of trade so that community welfare begins to fall. Somewhere in between there must be a tariff which will optimize a country's welfare level under these conditions he optimal tariff theory argues that a country that is a large importer of a particular commodity can shif the economic burden of an import tariff from domestic consumers to foreign suppliers if the country has monopsony power in the market-the country is a primary buyer from many competing suppliers. This monopsony power results in a supply that is relatively inelastic or insensitive to price changes, which forces exporters to lower their pre-tariff prices when facing a tariff increase in order to maintain the same supply level and allows importing countries to capture revenue that exporters previously received

2] Trade creation means that due to some bilateral or multilateral agreement between countries due to joining agreement trade has increased. This is known as trade creation. Trade diversion means that trade between two countries has been reduced because either country has moved out of trade agreement or bilateral agreement Trade creation leads to a gain of GI, but trade diversion leads to a loss of L, as the U.S. imports replace lower cost ROW imports. Depend on the extent of trade creation and diversion in many different markets. Equilibrium model that instead considers volume of trade and terms of trade effects When customs unions are established the flow of trade between countries involved in the new union and those outside will be affected. Customs unions eliminate barriers to trade between members, which is assumed to provide a considerable incentive to increase trade between members and to reduce trade between members and non-members. It is often easiest to appreciate the effect of a customs union by considering what happens when one country joins an existing union. Outside a union, and operating independently, a single nation will look to exploit its comparative advantage. In a free trade environment, countries will trade with who they like, attempting to exploit their own comparative cost advantage through specialization. They will export goods they produce most efficiently, and import goods from low-cost countries who have exploited their own comparative cost advantage to produce cheap exports. In a situation where countries do not trade freely, by imposing tariffs, or by favoring one country over another in terms of tariff levels, trade will be distorted and the pattern of trade will change. Inefficient producers may be protected and encouraged, at the expense of more efficient imports. The creation of a customs union, with common external tariffs, will further alter the existing pattern of trade flows Once a union is created, members agree to eliminate tariffs between themselves. The effect of this is that, tacing lower priced, zero-tarift, imports from members, consumers increase their demand for these goods, and new trade will be created a process called trade creation.